How Do You Repay a Debt Nobody Will Make You Repay? Promise in Advance

A borrower who owes a single large sum at a future date faces an obvious difficulty, which is finding that whole sum on the day. The arrangement addresses it by requiring regular payments into a separate fund throughout the life of the debt, so that the money accumulates gradually and is there when needed. Sometimes the fund buys back portions of the debt as it goes, retiring it in pieces. The essential feature is that the requirement is written into the borrowing agreement at the outset and is enforceable, rather than being left to the borrower's intentions, because intentions reliably weaken as the date approaches.

The provision changes the risk for whoever is owed the money:

• •Less owed at maturity, so less chance of default on the day
• •Visible evidence each year that repayment is being taken seriously
• •Steady buying supports the price of the debt in the market
• •Failure to pay into the fund is itself a breach, giving early warning
• •Lower risk usually means the borrower pays a lower interest rate
• •The borrower gains from that rate in exchange for the discipline

Britain established a fund in 1786 intended to extinguish the national debt entirely, under a scheme that attracted enormous confidence because compound growth made the arithmetic look magical. Money was paid in annually and reinvested, and projections showed the whole debt gone within decades. The flaw was that the government continued borrowing at the same time, and frequently borrowed at higher rates than the fund was earning, so the operation amounted to borrowing expensively in order to invest cheaply, which made the position worse rather than better. War from 1793 made new borrowing enormous. The scheme was wound down in the 1820s and stands as the standard warning that setting money aside is meaningless while still borrowing.

A borrower could achieve much the same result by repaying the debt in instalments from the start, and the difference between that and this arrangement is worth being clear about. An amortising loan reduces the principal directly with each payment, so the amount owed falls continuously and the lender receives the money as it comes. This arrangement leaves the debt outstanding at its full amount while money accumulates separately, so the borrower continues paying interest on the whole sum and holds a fund alongside it. That is worse arithmetically and better practically, because it fits debt that is traded in fixed units and cannot simply be paid down a little at a time.

Variants remain in wide use, and recognising them is useful because they are not always called by this name. Corporate bonds frequently carry a provision requiring a portion to be retired each year. Local authorities issuing debt for a specific asset are commonly required to set aside an amount reflecting the asset wearing out. Blocks of flats collect a reserve for major works such as a roof, which is the same idea applied to a predictable large expense. Sovereign funds built from resource revenue are a version aimed at a future without the resource. In every case the function is the same, which is converting one large future obligation into many small present ones.

Paying steadily into a separate fund converts one large future obligation into many small present ones, and writing the requirement into the agreement matters because intentions weaken as the date nears. Lenders accept a lower rate in exchange. The British scheme of 1786 failed because the government kept borrowing at higher rates than the fund earned, which made the position worse.