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Finance and capital markets
Course: Finance and capital markets > Unit 6
Lesson 9: BondsCorporate debt versus traditional mortgages
Understanding how most corporate debt is different than most personal mortgages. Created by Sal Khan.
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- So why do corporations and private citizens handle their debt differently? What's the benefit to a corporation to forever be paying interest and seeking new loans?(24 votes)
- I don't know for a fact that this is the reason, but I think it makes sense. When a person buys a house he does so to live there, he is not doing it for a profit. Therefore, he wants to own it, he doesn't want in any circumstance to be thrown out of it, even if he losses his job, a pay cut, a person never wants to lose it, as we could all witness what's going on today. That's why in the case of a home the person wants to pay up the principle as soon as he can and get ownership over it. In fact, some people would never even take out a mortgage on the home they live in for fear of one day losing it.
However, in the case of a corporation you could say it's just the opposite. The whole purpose of the investment is to make a profit, not to just hold the business indefinitely. So, if the company generates a profit and there is enough to pay the interest and some left over for the owners, then hallelujah, great, lets keep it running. In the event, however, that its not returning that kind of money then the owners say let the bank eat it, they have no more use in this enterprise any longer.
This might be a little oversimplification for some times the owners are just having a bad year, but you could always restructure etc. I think this would be the basic idea.(45 votes)
- Wouldn't it be better for the corporation to eventually pay off the debt, so that they have less liabilities?(12 votes)
- If you can borrow at 2% and invest that money in a way that grows your businesses profits at 3%, it's in your best interest to take on more liabilities.
Also, most business revolves around needing money now in order to make money in the future. You need money to pay employees, and develop, market and sell products. You get paid later when you successfully sell a product or service, but everyone else needs to get paid now. As a result, business runs on credit.(28 votes)
- What are some of these covenants at? 4:30(5 votes)
- Many of them relate to the retention of a certain debt to equity ratio, the pledge not to incur additional debt (except as authorized by the lender or other operational-related loans) and so on. Essentially promises to stay in the same or better financial health so as to protect the lender from risk of borrower's default down the road.(9 votes)
- On a mortgage, how much interest do you actually pay, rafly. Is it 100% of the principal?(6 votes)
- Could be more than that. Usually the interest it depends of other taxes that are variable. In Europe it is the Euribor. So we can't say precisely how much % of the principal it pays. The mortgage also depends of the time. A 10 years one is different from a 30 years one. Your amount of atives and money in the bank could also be an influence. With all these, an important mission it's keep attention to the market and times to times try to negotiate the interest based on other banks simulations.(4 votes)
- why T-bills return are called risk free ?(3 votes)
- T-Bills are considered risk free because there is, in practical terms, no chance that the US government will fail to repay.(8 votes)
- When were mortgages first used? Who invented these financial instruments?(4 votes)
- The word, mortgage, originates from two Latin words — mortuus vadium. Those words literally mean "death pledge." During the Middle Ages, in France, "vadium" was replaced with the French, "gage." Mortgage came to be apart of the English language in 1283. Valerie Hansen of Yale traces mortgages back to the silk trade during the Tang Dynasty in China from 7th to 10th centuries. To finance the silk trade, some people mortgaged their property or their slaves.
—http://oyc.yale.edu/economics/econ-252-11/lecture-10(3 votes)
- So ca, does the principal ever get paid back? 4:10(2 votes)
- Any time a bond matures, the principal is paid back. If not, the borrower is defaulting.
It is very common to pay off old debt with new debt. The original principal is paid back to investors and the company owes a new principal payment further out in the future.(4 votes)
- what about if the householder dies and still there's a principal and interest left to him/her? does mortgages take it back (the house )(2 votes)
- The estate has to either refinance the house or sell it.(3 votes)
- If I am a Bank, Why do i give loan that kind of risky company?(1 vote)
- So if a company were to keep getting loans to pay off loans, would it be possible for a company to never pay off their loans?(1 vote)
- Sure, they would just keep paying interest. This is actually the norm, not the exception.(1 vote)
Video transcript
The type of debt that most
of us are most familiar with are mortgages that we might
take out on our homes. What I want to do
in this video is clarify how a mortgage is
different than the type of debt that many corporations
would take on. So if I were to take out a
million dollar mortgage, what happens is is that the bank
figures out a fixed payment that I could pay,
really, every month. And as I pay that
payment-- and that payment will not change over the course
of the term of that mortgage, so maybe it's a
10-year mortgage-- the payment won't change. But as I pay that mortgage,
some part of it is interest, and some part of it is actually
paying down the mortgage. So early on in the
life of the mortgage-- maybe this is the first payment
here-- most of the payment is going to be interest, and
a little bit of the mortgage payment is going
to be principal. And when I say principal, that
little pink part right there, that's actually being
used to pay down the debt on the mortgage. So after this first payment, now
the debt is a little bit less. I'm going to make the same
total mortgage payment. But since the total
debt is now less, I'm taking the same
interest rate-- I'm assuming it's a
fixed interest rate here. But the amount of
interest is going to be less, because I paid off
a little bit of the principal already. So on the next payment,
the amount of interest is going to be a
little bit less. And for that fixed
payment that I'm making, I'm now going to be able
to give more principal. And we keep doing that. I want do that in
the same color. So the next payment after that--
that's not the same color. The next payment after
that, even though it's the exact same
payment, it's going to have less interest, because
I've paid down more of the debt now. So it's going to
have less interest. And it normally doesn't
happen this quickly, but hopefully this
gives you the idea. And it's also going to
have more principal. So that you fast
forward all the way to near the end of the term, so
this is many payments later. This is the end of the 10 years. I think I said this was
a 10-year mortgage loan. On that last payment,
even though every payment was exactly the same
amount-- the mortgage payment was the same dollar
amount every month-- that last payment is going to be
very little interest and mostly principal. And then after
that last payment, you would-- or if I'm that
person taking out the mortgage loan, I would have
paid off the loan. So loan paid off. And I own the house outright
in a traditional fixed rate mortgage. With corporate debt it's
not always like that. In fact, it's not
usually like that. Corporate debt is usually
interest only debt. And there usually might be some
things where the corporation has to pay off certain amounts
of the loans at certain times, but it isn't the model where
you have a fixed payment and you pay off the debt over
a certain amount of time. Most corporate debt-- let's
say a corporation takes a million dollars in
debt, and let's say it's a 10-year loan as well. But the corporation is just
going to pay the interest only. It is going to pay the
interest only the entire time. So whatever this
amount was, roughly, is what the corporation
will pay every month. So they'll pay exactly that
much every time period, maybe every quarter, every
year, whatever it might be. And then you fast forward to
the end of the term of the loan, so they continue paying
that same amount. And at the end of
the term of the loan they have to pay that amount,
plus all of the principal at once. Now, most companies won't have
all of that principal sitting around, whatever it might be. They have to pay all of
the principal at once at the end of the
term of the loan. Well, if they have the cash,
they could pay off the loan. But if they don't have the
cash-- and most corporations would not have the
cash in this situation. That's why they borrowed it
in the first place-- what they would do, is they
would take out a new loan. So they would take
out a new loan for the same amount
of principal, maybe to the same bank,
maybe a different bank. But it might now have
a different interest rate, different loan
terms, whatever. So they'll now
take out a new loan at the end of the
term period, use that to pay the principal
on their old loan. And then they'll
continue paying interest for the term of this new loan. So it's a slightly
different process, and I just wanted to make
sure you understood that. And the other thing, this
isn't all corporate debt. They could be fixed interest
rate, floating interest rate. There's often things
called covenants that the bank will
place on the corporation to make sure that the
corporation isn't doing dangerous things that will make
it less likely that they'll eventually be able
to pay off the debt, or less likely they could
eventually get a loan to pay off the current loan. So there are controls
that the bank has to make sure
that the company is good for this near
the end of the term. But as you can see, it's a
fundamentally different process than most mortgage loans.