There are various debts out there. It might seem like a sea of varying types when one is trying to find the right one. Whatever the case may be, knowing the fundamental structure of the types of loans or bonds out there reduces this to just four main types.
To begin, we need to step into the financial world to see this understanding. In finance, a loan can be recognized as a bond which is defined as a debt security—a promise to make periodic payments for a specific period of time. Bonds and loans share the same purpose of a lender providing money to a borrower; however, a bond can be traded in a market whereas loans are most likely to be agreements between banks and customers. This definition expands our horizon into loans not heard of on a day-to-day basis, but we won’t delve into that subject. As far as we are concerned, we are only interested in the basic forms. There are four main structures that encompass a debt security—bond or loan—from which our sea is built on: simple loans, fixed-payment loans, coupon bonds, and discount bonds.
A simple loan is what comes to mind when talking about loans. It involves the lender providing money to the borrower and expecting the original amount at some point in the future along with some interest.
A fixed-payment loan is exactly what the name implies: it consists of fixed payments to the lender from the borrower every period—monthly, for example—for a number of years. The fixed payments comprise part of the original borrowed amount—called the principal—and the interest. This way, the borrower is partially paying off the interest and the principal every period. Many mortgages are fixed-payment loans.
A coupon bond is similar to a fixed-payment loan however the fixed payments consist of only the interest. In other words, borrowers make periodic payments to the lender consisting of only the interest until the end of the loan—called maturity—when the principal is paid back. The periodic payments between the beginning of the loan and maturity pay back the interest.
Discount bonds can be thought of as buying a loan at a discount. A discount bond is a loan that is bought for a lower price and the borrower pays back the principal at maturity. For example, a $10,000 discount bond could be sold for $8,000: the borrower pays $8,000 and the lender gives him a $10,000 bond. At maturity, the borrower pays the lender $10,000. This is hypothetically speaking of course but the idea is there.
Having this basic understanding of the various debt securities out there gives us an advantage when we plan our financial future. Regardless of how the loan is advertised or how lenders can seemingly simplify complicated debts, fundamentally speaking, we can build our understanding of any type of debt security out there by keeping the four main structures in mind. From financing our education to buying our first house, understanding a loan’s basic form allows us to know what to expect when the bills come in and adapt our financial stance in a sound manner.