What Does PIK Interest Mean?
PIK, or payment-in-kind, interest is the option to pay interest on debt instruments and preferred securities in kind, instead of in cash. PIK interest has been designed for borrowers who wish to avoid making cash outlays during the growth phase of their business.
Divestopedia Explains PIK Interest
PIK interest is usually presented as additional securities, issuance of additional debt instruments or increases in the principal of existing debt. Generally benefiting the borrower, one setback is that a PIK instrument usually has a higher interest rate than its non-PIK equivalent (such as cash and other bank notes) in order to make it an attractive option for the collector.
For example, an IT company wishes to expand and construct a new building, but does not have enough cash at the moment. They opt to take out a loan using PIK interest with five years of maturity. The amount that they borrow, or their principal balance, is $1,000,000 with a 2% PIK interest compounding annually. During the first year, the interest will be $20,000 ($1,000,000 x 2%). This $20,000 will not be paid in cash yet, rather it will be added to the principal balance, so the principal note now becomes $1,020,000. During the second year, the 2% interest still applies to the principal note, so the interest for the second year will be $20,400 ($1,020,000 x 2%), making the total money loaned by year two $1,040,400. The same caluclation goes on through the fifth year until the agreed upon date of payment when the total amount is then paid in full.