Balloon Interest - Explained
What is Balloon interest?
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Table of ContentsWhat is Balloon Interest?How Does Balloon Interest Work?Calculating Bond Interest RatesAcademic Research on Balloon Interest
What is Balloon Interest?
Balloon interest refers to paying a higher coupon rate on financial instruments held over the long term within a serial bond issue. A serial bond issue has its bonds maturing at different dates but a term issue bonds mature at a specific date with the rest.
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How Does Balloon Interest Work?
Ballon interest comes to play in a serial bond interval when the bonds mature at different intervals but an important part of the bonds mature exactly the same date. A serial bond is structured to have different maturity dates, but a part of the bond can mature together. The bonds mature gradually over a period of time. The bonds are specifically used to fund projects which will continually yield income for bond repayment. Bonds sold have documented details with included maturity dates. It is possible to earn high interest and also extend the bonds when a serial bond has been issued, due to the reason that the investor is making more profit and wishes to hold the instrument longer. Investors refer to this coupon rate as balloon interest. Serial bonds are acquired so as to fund projects which is projected to have a stable means of income at the point of paying or when balloon interest is due. A part of the bonds or the bulk of the bonds may mature at the same time while the rest mature at different intervals, but when the majority of the bonds mature at the same time, it is referred to as a serial bond with a balloon. The balloon is used due to the fact that a large percentage of the term bonds matured in the final year of the issue's term.
Calculating Bond Interest Rates
When a rate is able to reduce all of the future cash receipts to the amount of cash paid to purchase the bond, then that's the actual, real, or effective interest rate. This interest rate is also referred to as the yield to maturity or market interest rate. The actual or real interest rate of a bond is calculated by multiplying the bond interest rate against the actual amount of the bond against one-half of a year plus the maturity amount of the bond. This could be done using a financial calculator or value software. The maturity amount to be paid is done once. When the interest rate of the bond rises above the current market interest rate, it will result in market value which is higher than the maturity or actual amount of the bond. The bond will sell at a premium price but on the other hand, when the bond's interest rate is lower than the present market interest rate, the bond's market value will be less compared to the maturity or actual amount of the bond. Then the bond will sell at a discount. Zero-coupon bonds are paid at maturity. At this time, their prices are likely to change suddenly unlike coupon bond pricing. Zero-coupon bonds are traded at a discount, and they allow for-profit at maturity when the bond is bought for its actual value.