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Not sure if this is the right place for this question but it's more of a theoretical finance question than a personal finance question.

So a loan has a principal amount that is given to the borrower in a lump sum, and the borrow then pays back that amount plus some interest. For example, let's say that George loans \$100 to Fred at 10% interest over 10 months. Fred then pays back at \$11 a month and is debt free at the end 10 months.

Is it ever the case that George lends the money in increments instead of a single lump sum? That is, George pays Fred \$20 a month for five months, while at the same time Fred pays back at \$11 a month for 10 months.

I ask because this would be less useful to Fred but less risky to George.

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  • $\begingroup$ What are the economic principles you are asking about? $\endgroup$
    – 410 gone
    Jan 22, 2016 at 14:12
  • $\begingroup$ Sorry, I meant the principal, as in the amount owed: investopedia.com/terms/p/principal.asp $\endgroup$
    – Dave
    Jan 22, 2016 at 14:26

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Handing out the principal amount of debt gradually, in increments, is standard practice in investment loans extended by a bank to a corporation.

The rationale is clear : the corporation wants to make an investment, say a new factory. The whole plan is laid out and the cash flows of the pre-operational, construction period are also detailed, based on forecasts or specific agreements with the suppliers (contractors etc) that will be involved. The bank checks and accepts all these, but it also wants to see the corporation deliver (both the corporation's part in the financing but also as regards the actual build up of the investment).

So specific milestones are agreed between the two parties, and to each milestone a round of financing is agreed (these milestones become contracutal obligations, legally binding). Milestones usually include specific technical phases of the build up to be accomplished (say, the building's foundations are complete, or the power infrastructure has been installed, etc).

In this way risk is reduced without hurting the necessary cash flow for the project. It also reduces the interest burden for the firm.

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  • $\begingroup$ Is there a particular name for this style of loan? $\endgroup$
    – Dave
    Jan 22, 2016 at 15:54
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    $\begingroup$ @Dave It is usually a bond loan. $\endgroup$
    – Alecos Papadopoulos
    Jan 22, 2016 at 16:13
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In the United States construction loans often work this way:

Once approved, the borrower will be put on a bank-draft, or draw, schedule that follows the project's construction stages and will typically be expected to make only interest payments during construction. As funds are requested, the lender will usually send someone to check on the job's progress.

How do home construction loans work? By Steve McLinden • Bankrate.com

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  • $\begingroup$ Thanks for the response and link. I'm accepting Alecos' answer because he was first. $\endgroup$
    – Dave
    Jan 22, 2016 at 15:54

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