Loan Repayment

What is loan repayment?

Loan repayment (Tilgung) describes the repayment of the borrowed principal of a loan to the lender, in instalments or in a lump sum. It is to be distinguished from interest, the consideration for making the capital available. Under Section 488(1) of the German Civil Code (BGB), the borrower owes the agreed interest and repayment of the loan when it falls due. When and in what steps repayment is made is regulated by the repayment schedule in the loan agreement. The principle is familiar from the car loan: part of each monthly instalment reduces the outstanding balance, and that is the repayment; the remainder is interest.

Interest and repayment together form the debt service. The repayment structure determines how heavily a loan burdens ongoing liquidity and thereby decides debt service capacity. It belongs in every financial model for a financing round, is reviewed in due diligence and, in a company sale, determines the outstanding balance to be repaid at closing.

Loan repayment in the balance sheet, income statement and tax

Repayment is not an expense. On the liabilities side it reduces liabilities to banks and on the assets side cash, while equity remains unchanged. In the income statement only the interest appears. In the cash flow statement, which explains the change in cash by cash flows, repayment counts towards cash flow from financing activities and not towards operating cash flow.

From this follows a divergence between earnings and liquidity: a company can report an annual profit and still lose liquidity if repayment exceeds operating cash inflow. For tax purposes, repayment is not deductible. Interest is in principle a business expense. With high interest expense, the interest barrier (Zinsschranke) limits the deduction (Section 4h of the German Income Tax Act, EStG, and Section 8a of the German Corporate Income Tax Act, KStG), and for trade tax part of the interest is added back to profit. The funds for repayment must therefore come from cash flow after tax. The most important source is depreciation on the financed asset, which reduces taxable profit without liquidity flowing out.

Repayment forms and calculation of repayment

Annuity loan

The instalment of interest and repayment remains the same over the term (annuity). Because interest accrues on the falling outstanding balance, the interest share of each instalment decreases and the repayment share increases. The constant burden makes the annuity loan easy to plan; it is common for investment and property financing.

Formula: annuity = loan amount × i × q to the power of n ÷ (q to the power of n minus 1); i = interest rate per period, q = 1 + i, n = number of instalments

Formula: repayment per instalment = annuity minus outstanding balance before the instalment × i

In property financing, the instalment is often set via an initial repayment rate, that is, the percentage of the loan repaid in the first year. The annual instalment is then loan amount × (nominal interest rate + initial repayment rate).

Instalment loan

With an instalment loan (Ratendarlehen, also called a reducing loan), the repayment amount is the same in each period, namely loan amount ÷ number of instalments; the total instalment falls with the outstanding balance. The initial burden is above that of an annuity, the total interest below it. An innovation loan and other promotional loans often provide for this form, usually after repayment-free start-up years.

Bullet loan

During the term only interest is paid; the entire amount falls due in one sum at the end (fixed-term loan). This protects ongoing liquidity but leads to the highest total interest and to a final payment that can usually be raised only through refinancing, sale proceeds or saved funds. An intermediate form is the loan with an increased final instalment, in which part is repaid on an ongoing basis and the rest at the end. With a repayment-suspension loan (Tilgungsaussetzungsdarlehen), the borrower pays into a savings product instead of repaying, such as a life insurance policy or a home loan and savings contract (Bausparvertrag), from which the debt is settled at the end.

Repayment-free start-up period and special repayment

A repayment-free start-up period postpones the start of repayment by one or more years while interest is paid on an ongoing basis. It suits investments that bring returns only after a start-up phase, but does not remove the burden; it compresses it into the remaining years.

A special repayment right allows unscheduled repayments without or with limited compensation. If it is absent, a loan with a fixed interest rate can usually be redeemed before the fixed rate period ends only by agreement; the lender then demands a prepayment penalty (Vorfälligkeitsentschädigung) for the lost interest income. The borrower can terminate a loan with a variable interest rate at any time with three months' notice under Section 489(2) BGB.

Loan repayment at young technology companies

Banks size repayment schedules by the expected earning power and by the useful life of what is financed. For companies with negative operating cash flow, this is the real hurdle: any repayment that does not come from the ongoing business is in effect paid out of the equity of the last financing round. Investors take a critical view if a considerable part of newly raised funds flows into repaying old loans instead of into product and sales.

Debt capital therefore sensibly complements equity where repayment and cash inflow match in time. An example is a loan for hardware or sales expansion that is repaid from growing recurring revenue after a repayment-free phase. With venture debt, loans to venture-capital-financed companies, an initial phase without repayment followed by repayment in equal instalments is common. Repayment then often begins before the company is profitable and thus often depends on a further financing round.

Loan repayment in due diligence and company sale

In due diligence, the review by investors or buyers, repayment schedules are reconciled with liquidity planning. Conspicuous are repayment peaks in the planning period, such as bullet amounts or the end of repayment-free years, for which no refinancing is apparent.

On a sale, what counts is not the repayment schedule but the payoff amount at closing. Many loan agreements allow the lender to terminate on a change of control (change of control), and the acquirer's financing often replaces the existing loans in full. With a purchase price on a cash-free/debt-free basis, the outstanding balance, including accrued interest and any prepayment penalties, is deducted from the enterprise value as part of net debt. This also applies to shareholder loans. The outstanding balance thus reduces the equity value, that is, the purchase price for the shares, and the sellers' proceeds.

Worked example: calculating repayment under four repayment forms

A software company finances server infrastructure and the expansion of its sales organisation with a loan of EUR 1.2 million, term six years, interest assumed at 5% per year, annual payments. Four repayment variants are compared.

• Annuity loan: constant instalment of around EUR 236,421, sized by the annuity formula so that the loan is repaid after six instalments. In the first year, EUR 60,000 of this is interest (EUR 1.2 million × 5%) and EUR 176,421 is repayment. In the sixth year it is around EUR 11,258 of interest and EUR 225,163 of repayment. Interest over the term: 6 × EUR 236,421 minus EUR 1.2 million = around EUR 218,526.
• Instalment loan: repayment EUR 1.2 million ÷ 6 = EUR 200,000 per year. Instalment in the first year EUR 200,000 + EUR 60,000 interest = EUR 260,000, in the sixth year EUR 200,000 + EUR 10,000 = EUR 210,000. Interest over the term: 5% × EUR (1.2 + 1.0 + 0.8 + 0.6 + 0.4 + 0.2) million = EUR 210,000.
• Bullet loan: EUR 60,000 of interest per year, in the sixth year additionally EUR 1.2 million of repayment, together EUR 1.26 million. Interest over the term: 6 × EUR 60,000 = EUR 360,000. The final repayment alone equals twenty times the annual interest payment.
• Instalment loan with one repayment-free year: in the first year EUR 60,000 of interest, then five repayment instalments of EUR 240,000. Instalment in the second year EUR 240,000 + EUR 60,000 = EUR 300,000. Interest over the term: EUR 60,000 + 5% × EUR (1.2 + 0.96 + 0.72 + 0.48 + 0.24) million = EUR 60,000 + EUR 180,000 = EUR 240,000.

The bullet loan costs around EUR 141,500 more in interest than the annuity and EUR 150,000 more than the instalment loan. The repayment-free year lowers the burden in the first year from EUR 260,000 to EUR 60,000, raises total interest by EUR 30,000 and lifts the highest annual instalment to EUR 300,000. In the first year of the annuity, only EUR 60,000 of interest reduces earnings, whereas liquidity falls by EUR 236,421.

Distinctions: repayment, depreciation, amortisation and repayment grant

• Depreciation: the allocation of the acquisition cost of an asset over its useful life. It is an expense without cash outflow and thus the counterpart of repayment, which costs liquidity but is not an expense.
• Amortisation: in German usage mostly the payback of the capital put into an investment (Amortisation) and, following English usage, also the write-down of intangible assets. In English, amortisation additionally stands for the scheduled repayment of a loan.
• Refinancing (Umschuldung): the replacement of an existing loan by a new one. It changes the repayment schedule but is not a repayment from own funds.
• Repayment grant (Tilgungszuschuss): the part of a promotional loan that the promotional bank waives if the funding conditions are met. It is offset against the outstanding balance and need not be repaid.

Common mistakes

• Repayment planned as an expense. Anyone who deducts repayment in the earnings plan underestimates profit and tax burden and still does not map the actual liquidity requirement correctly.
• Term and useful life not aligned. If repayment is faster than the financed asset generates returns, avoidable liquidity pressure arises; if financing runs longer than the asset is used, there is no room for the replacement investment.
• Bullet maturity without a follow-on plan. A bullet sum requires refinancing, the preparation of which must begin long before the due date.
• No special repayment right. Without a contractual right to early repayment, a prepayment penalty makes redemption more expensive, for example on a company sale.
• Repayment out of the round's equity. If loans are repaid predominantly with newly raised equity, that equity is missing for the growth on which the valuation of the round was based.

Frequently asked questions

Which repayment form suits a growth company?

Usually an instalment loan or an annuity with a repayment-free start-up period. This way repayment begins only when the financed measure generates returns. Bullet structures make sense only if there is a realistic route to the final payment, such as a foreseeable follow-on financing.

How is repayment calculated?

For each instalment: repayment = instalment minus interest, and interest results from the outstanding balance times the interest rate. With the instalment loan the repayment is fixed; with the annuity loan it grows from instalment to instalment. A repayment schedule lists interest, repayment and outstanding balance for each instalment; repayment calculators and spreadsheets produce it using the annuity formula.

How long should the repayment period be?

Roughly as long as the economic useful life of the financed asset. Working capital is repaid in the short term, hardware and machinery over a few years, property over decades.

What is a prepayment penalty?

Compensation for the interest loss that the lender suffers through early repayment of a fixed-rate loan. Its amount depends on the remaining term, the agreed interest rate and the interest level at redemption. Agreed special repayment rights limit or avoid it.

Can repayment be suspended?

Only with the lender's consent. Banks agree to repayment suspensions if a temporary bottleneck is explained plausibly and backed with a plan. Interest generally continues to run, and the suspension is often tied to additional information obligations or security.

Does fast repayment improve creditworthiness?

In the medium term yes, because it lowers indebtedness. In the short term, excessive repayment can burden liquidity so much that debt service capacity suffers. For creditworthiness, what counts above all is therefore that the repayment schedule is sustainable in the long term.

The Roemer Capital view

In the financial model, Roemer Capital keeps interest and repayment separate: interest in the income statement, repayment in liquidity and balance sheet planning. Only this separation shows whether a planned surplus is actually available as liquidity or is consumed by debt service. Repayment peaks are set against the runway before a company goes into a financing round.

In a sale process, Roemer Capital requests the payoff amounts of all loans for the planned closing date early, including any prepayment penalties. This way the bridge from enterprise value to the purchase price for the shares is in place before the acquirer presents its own calculation.