Lenders have various ways to structure loans. The loan’s interest rate, amortization and term all affect how the loan is structured.
Understanding Term & Amortization
Amortization describes how the monthly payment is calculated over the life of the loan. Typically for airplanes, the life of the loan—the amortization period—is 15 years or 20 years. The interest rate charged is included in the amortization schedule for the loan. The “term” indicates when the full balance of the note is due.
If a loan’s term and amortization match, it’s called “fully amortizing.” Sometimes, it’s in the best interest of both parties for the lender to structure a loan where the term is not fully amortized. This loan structure is often called a “balloon.”
For example, you might get a balloon loan with a 20-year amortization and a five-year term. First, the lender will calculate how much principal and interest you owe every month, over 20 years. Next the lender will calculate the balloon term, in this case, five years. After five years, the balloon payment—the lump sum equal to the remaining 15 years’ worth of the loan principal—would be due. Lenders can structure balloon terms out to 10 or 15 years on a 20-year amortization.
Advantage of a Balloon
One advantage of a balloon note is that the lender may be able to offer a slightly better interest rate as they themselves wouldn’t be subject to the same interest rate exposure in the short term compared with a longer, fully amortizing term. An advantage to you is the savings in interest you otherwise would have had to pay by keeping the loan over a longer period of time . You could think of the balloon as a massive pre-payment, without penalty.
Pre-payment Penalty
Speaking of which, buyers often want to know whether they’ll incur a prepayment penalty if they pay off an aircraft loan early. It depends. Not all lenders have prepayment penalties. Those who do use them to help cover their cost to carry the loan.
One of the ways lenders earn their money is based on the difference between their cost to lend the money, and the interest they charge for people to borrow money, which is commonly known as “net interest margin.” When lenders issue loans, they make assumptions about how long that loan is likely to be in place. If someone pays their loan off in a shorter time than anticipated , the bank potentially loses money on that loan.
To mitigate or prevent this kind of loss, some lenders will include in the loan documents a prepayment penalty. In most cases, prepayment penalties will be in effect for somewhere between the first six months to the first 36 months of the loan term. In these cases, if you pay off the loan within the prepayment penalty period , a fee will be assessed in order to close the loan. This is not to say that any additional principal payments will incur a fee. Most lenders will allow extra principal payments during the prepayment penalty period as long as the loan is not paid in full.
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