Bond Basics – Interest and Maturity

March 23rd, 2012 by

All bonds have a face value amount and a maturity date. You can think of a the maturity date as the end of a life for a bond. At the maturity date, the holder of a bond is paid the face value of the bond by the issuer.

Lets say you buy at bond at face value and hold it until the maturity date. If no other money exchanged hands, you would not have made or lost any money in terms of dollars. However, you actually would have lost value – $1 today buys less than it did 5 years ago. No one would loan money if they did not receive something extra to compensate for the potential loss of value and the risk of not getting paid.

When it comes to bonds, that something extra is called interest.

Interest is the money that someone who borrows money, pays the person or entity that lent them that money.

Interest is almost always talked about in percentage terms of the money being borrowed. For example 7% interest on $1,000 would equal $70. However, when a person says the interest is 7%, they usually mean 7% interest per year.  If you bought a bond for $1,000 with a 7% interest rate and maturity date of 10 years, you would receive a total of $1,700 in payments for the during the life of the bond. ($70 per year x 10 years + $1,000 on the maturity date).

 

If the example above was a little complicated, here is another one to help you get your head around this vital and central concept.

Lets say that you want to start a new business, but need a loan to help you get started. Because you have a good relationship with your local banker, and are an upstanding citizen, he agrees to give you a loan for $50,000 to start your business with.

While you and your banker are friendly, you understand that he is in business to make money. How you banker earns his living is by charging you interest on the loan that he provided. When making the loan for your business, lets say he considers all the factors and decides to charge you 10% a year on your loan. This 10% is the interest he is charging on your loan, and means that you are going to be paying $5000 (10% of $50,000) a year for the opportunity to use the $50,000 he loaned you.

Anytime you think about interest, if you can think about it in the context of the above example it will help out a lot, as at the end of the day whether you are talking about taking a loan from a bank, using a credit card, or buying a bond it all comes down to interest.

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