Here is a brief discussion long promised on advance vs arrears payments.
Advance or Arrears Payments:
Typically, payment of interest for the use of money is made at the end of the period of use of the money. As an example, most mortgages are paid at the end of the month for the use of money during that month. Similarly, the principal portion of the payment is made together with the interest after the month expires or in "arrears". In some cases, loans or lease payments are made having payments in the beginning or the inception of the loan or lease before the lapse of any time in the contract. This loan would be referred to as having an "in advance" payment structure. So, what's the difference in rate effect and cash flow? Why is it done?
The change between advance and arrears can have a major impact on the rate of interest in the loan or lease. Some loans or leases can require two or more payments in advance, or other in advance payments for fees etc. The impact of any "in advance" payments for any reason by whatever they may be called, is to reduce the amount of initial investment by an amount equal to the in advance payments. Making the initial investment for the same loan/lease smaller while the pay back stream remains the same increases rate of return. The smaller the investment the higher the rate of return on the investment, all other things being equal. There is an endless list of fees and expenses a lender can charge or pass on to the borrower. Whatever the name, if the borrower pays over to the lender some amount, that amount serves to enhance the lenders yield or rate on the deal.
Assume a business loan of $95,000 to be paid back monthly over 18 months with a rate of interest at 18% and an in arrears payment of $6,061.55. The stream rate is given as 18% and could be quoted as such.
If the lender were to require one payment in advance then the amount being loaned would reduce to (95,000-6061.55) or 88,938.45. The resulting rate to present value the stream of payment back to 88,938.45 is 26.95%,
If the lender required the 1st two in advance the rate jumps to 36.84%. The stream rate can still be said to be 18% while the actual rate is 36.84%.
If the lender required the 1st plus the last two payment in advance we get 95,000-(3 X 6061.55)) or an net investment of 76,815.35. The rate increases to 47.85% with three in advance. The stream rate is still quoted as 18% while the effective rate has jumped to 47.85%. Wow...big difference.
Next let's assume a placement fee is charged, or call it a set up fee of 3% or 3,135 (.03 X 95,000). The net out of pocket to the lender drops from 76,815.35 to 73,680.35. The rate now goes to 54.06%.
So we have the first and last two in advance and a set up fee of 3%. We quote 18% on the stream and create a transaction returning 54.06% effective rate. That is what "in advance vs. in arrears" can do to the bottom line. The borrower needs the money and is often thankful that he has a resource at any rate, so he is willing to pay it even if he is aware of the material increase in rate created by in advance payment requirements. Many a small business would not survive without this resource. Banking requirements are unrealistically restrictive, and poorly executed. Too much emphasis on rate will often mislead a borrower.
These rates can be developed using a financial calculator. Having PAMS-DCF software to produce amortization schedules gives a better picture of the earnings spread over the term. This concludes our discussion of in advance in arrears scenarios.