By Foluke Akinmoladun
A ship-owner with stable and predictable cash flows throughout the life of the loan:
The most suitable loan structure that may be undertaken by a ship owner with predictable cash flows is an amortised loan. An amortised loan is a loan that is repaid in a predetermined regular amount that reduces both the principal and interest payments on a monthly basis. Amortization spreads out the loan repayment into multiple fixed payments over the tenure of the loan. The periodic payments made in a series of fixed amounts are in the early stages used to cover majorly the interest payments and later to reducing the principal amount.
An amortizing loan is organized such that it completely pays off the outstanding loan balance over a period of time.
The ratio of principal and interest in an amortised loan changes throughout the repayment period. These changes are because the initial repayments pay off more interest than principal and this balance changes over time. Deducting the principal amount from the outstanding loan amount results in the new outstanding loan balance. The new balance will be used to calculate the interest payment for the next repayment period. The change in principal and interest is detailed in an amortization schedule.
The primary advantage of amortization is that it is a tax deduction in the current tax year, even if the ship owner did not pay cash for the asset. As long as the asset is in use, it can be deducted from the ship owner’s tax burden.
Additionally, it allows the ship owner to have more income and more assets on the balance sheet.
It also allows the ship owner in this scenario to make use of its regular cash flow to be able to compute the monthly repayments such that as the principal balance is reducing, so also is the cost of capital that is paid therein. With the combined effect of capital allowance and interest/monthly repayments, the ship owner can also significantly reduce its tax exposure through the lifespan of the loan.
A ship owner who anticipates good profit on disposal of a vessel at the end of the loan term but will be trading the vessel in an unpredictable spot market:
A ship owner that anticipates a good profit on disposal of a vessel can take advantage of a balloon loan. A Balloon loan is a loan whereby at the end of the loan tenure, a lump sum is paid that is significantly larger than all of the payments made before it.
Balloon payments allow ship owner borrowers to reduce the fixed payment amount in exchange for making a larger payment at the end of the loan’s term. In general, these loans are good for borrowers who have excellent credit and a substantial income.
Balloon payments are generally defined by being at least twice as large as regularly scheduled payments. By making one large lump sum payment, balloon loans allow ship owner to lower their monthly loan repayment costs in the initial stages of paying back a loan.
A ship owner in this situation has to trade in an unpredictable spot market, which means there is a possibility of low cash flows at certain periods early during the loan term. Having a balloon loan will enable the ship owner to have smaller repayments before maturity to take advantage of the good profit on disposal of the vessel. It also allows the ship owner to take advantage of a lower repayment amounts made during the tenure of the loan. In addition, since balloon loans usually have shorter terms than traditional instalment loans, with the large payment typically due after a few months or years, the ship owner can take advantage of disposing the vessel before the vessel begins to lose value.
Balloon loans are also helpful to a borrower who wishes to minimize short-term loan costs to free up capital. Therefore, balloon loans are useful for ship owners who have immediate financing needs and predictable future income.
Despite their reduced initial payments, balloon loans are riskier than traditional instalment loans because of the large payment due at the end. As such, most lenders will only provide these loans to ship owners that are highly credit worthy with sufficient cash and relatively stable income streams. It also poses a higher risk than traditional loans because of the higher possibility of default at maturity. This should not be an issue here, as the vessel’s value will compensate at maturity for the liquidation of the balloon payment.
Foluke Akinmoladun is a lawyer, accountant, mediator and arbitrator. She is the Managing Solicitor of Trizon Law Chambers and can be reached at: Foluke.A@trizonlawchambers.com