What Makes a Partially Amortized Loan Different
A partially amortized loan is a special type of liability or obligation that involves partial amortization during the loan term and a balloon payment—lump sum—on the loan maturity date. Amortization is the spreading of payments into smaller, regular payments such as you would see on a loan for a car. With partially amortized loans, only a portion of the full loan value is amortized with the balance being due on a specific date.
These loans are commonly found in certain commercial lending arrangements, such as hotel financing. They allow the bank or financial institution to set a fixed interest rate for a certain period like seven or nine years. The loan requires much lower payments than would otherwise be possible, allowing the project itself time to grow and appreciate or begin to earn revenue.
This is beneficial for both the borrower and the lender. The lender doesn't have to take on significant duration risk. Longer notes have the real possibility of inflation reducing the final maturity value of the collateral underlying the loan.
Despite their potential cash flow benefits—and they can be useful, especially for certain types of operating firms—perhaps the biggest danger with taking on a partially amortized loan is almost always the massive repayment that is due at the end of the contract. A common mistake people make is assuming they'll be able to refinance.
Refinancing is not always available and if it is, it's not always available on economically acceptable terms. The bankruptcy court records are strewn with corporations, partnerships, and individuals who were generating large profits or enjoying a significant, stable income only to find that the world fell apart and nobody was there to cover the gap.
Partially Amortized Loan vs. Fully Amortized Loan
Imagine you wanted to take on a $1,000,000 partially amortizing loan. You have a fixed interest rate of 8.5%. The bank agrees to give you a seven-year maturity with a 30-year amortization schedule.
Your payment is going to be $7,689.13 per month. You'll end up paying $645,886.92. At the end of seven years, you'll owe a lump sum of $938,480.15, and you must repay the entire amount somehow or you'll default. If you default the bank will seize the collateral and perhaps force you or the project to declare bankruptcy depending upon how it is structured. You'll end up repaying $1,584,367.07 in total.
In contrast, if you had a traditional, fully amortizing loan with a seven-year maturity, you would have paid $15,836.49 per month. You'll end up repaying $1,330,265.16. At the end of the term, you'll owe nothing. The balance is repaid in full.
Why Companies Use Partial Amortization
Why would someone opt for the partially amortized loan in this situation? Despite the higher cost and the end-period liquidity demand, for seven years, the borrower got to enjoy $8,147.36 more cash each and every month than he or she otherwise would have as a result of the lower monthly payment.
That could have given the project enough time to get off the ground or to sell whatever it was that the backer was developing. In other cases, the theory is the underlying business growth will be sufficient to wipe out the balance (e.g., a fast-expanding beverage company that can't keep up with demand so it builds a much larger factory that, at its rate of the current expansion, should make the balloon payment a rounding error).
Aside from its alternative, the fully amortized loan, there is also a non-amortizing loan or "interest-only" as it is more frequently called. Most bond investments are structured this way. Here, the borrower will pay only the interest due on the note with each payment. On maturity of the loan, the borrower has to pay the principal or get a new loan.