Another somewhat common type of loan is known as an interest-only loan. So I'll be talking all about interest-only loans in this screen cast. A typical loan and amortized loan, you make loan payments to payoff that principal over time. So if we start with a principal original loan amount, we are interest we pay a monthly payment the next month we have a little bit smaller principle which earns interest. We make a monthly payment and we slowly over time will diminish that principal, and that's how we payoff that loan. An interest-only loan is little bit different. We start with a principal so you take a loan, you pay for a house or whatever and you have your loan amount, it makes interest and then you pay this off with a monthly payment. For an interest-only loan, the monthly payment or this green arrow here is identically equal to the interests that was accrued during that month. So we payoff that interests, the principal at the end of the month is exactly what it was the previous month or compounding period. So that next month we earn the blue amount here of interest, we pay it off exactly with a monthly payment that offsets the interest to bring that back down to the original principal or the original loan amount. This is like pruning a tree. So a tree will grow more leaves and you just trim them off. Each summer or each month, you get a little bit more growth, then you trim it off. So that's what happens in an interest-only loan, we make interest and then we pay it off exactly. The principal never gets any bigger and it never gets any smaller. So in an interest-only loan, the payment that is made on the loan is only the interest earned each period. We can calculate the payment. The payment is just equal to the interests, the interests is equal to the principal times the rate times the time for that period. For example, what's the monthly payment on an interest-only loan with a principal of $10,000 if the annual interest rate is four percent and the interest is compounded monthly? Well, we can just use that formula, we can take $10,000 that's our principal, times the rate for one month, it's four percent, that's our annual percentage rate but it's compounded monthly. So we can perform this calculation, and that means each payment is $33.33 in this case. The really important thing about an interest-only loan, well, one, you're making smaller payments on that loan because you're basically making the minimum payment on that loan to prevent the principal from increasing. But the important thing is at the end of the interest-only loan, you still have a balance of the original loan amount. So if you borrow $10,000 initially, you have to pay that off. You can pay that off a couple of different ways. Some of these require you to make a single balloon payment, and this is typical of large companies that have a lot of money or perhaps this is for a real estate investments. So at the end when you sell that house or whatever, you've got a large chunk of money, or sometimes you can take your interest-only loan and then you can take the principal at the end, and you can just convert that to an amortized loan that you can payoff slowly, payment by payment over time. Let me show you how we can do this in Excel, this is in a file called interest-only loan. We have our loan amount and that's positive because we took that money, it came into us positive cash flow. We have an annual interest rate of 0.04 and we can calculate the payment by just taking the principal, multiplying that by our annual interest rate, we divided by 12, because that's compounded monthly and we multiply that by one month. So this means every month, we make a payment of $33.33. I did not use an Excel function for this, so it does not have a negative sign. But really this is an outflow because we're making a payment to the bank. So this really should be negative if you're using the sign convention that Excel does. We can make a quick amortization schedule, I'm just going to go up to 10 months here. It's quite boring as you'll see. So the interest here is just our beginning balance times our interest rate up here, I'll make that at a four divided by 12 times a single month. So it turns out the interest is the same as the payment. But the payment is equal to cell B5, and I'll make that F4 absolute reference. The ending balances is the beginning balance plus the interest made minus the payment. So all we get, is we get back to the ending balance. This is quite boring because if I copy this down and then I copy this row down for the 10 months, it's all the same. That's the amortization schedule for an interest-only loan. You see that after 10 months, we still have a balance of $10,000, which is the same as the loan amount. So at some point, you're going to have to pay this back to the bank either in one balloon payment, that's one lump sum, or by taking this and getting an amortized loan for it that you can payoff slowly over time.
