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Corporate debt versus traditional mortgages

Understanding how most corporate debt is different than most personal mortgages. Created by Sal Khan.

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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.