## What is PIK Interest?

**PIK Interest**, or “paid in kind” interest, is a feature of debt that allows interest expense to be accrued for a set number of years, rather than being paid in cash in the current period.

In exchange for the deferred payout of the cash interest expense and the borrower retaining the cash for additional time, the debt principal coming due on the date of maturity increases.

## How to Calculate PIK Interest (Step-by-Step)

PIK interest stands for “** P**aid-

**n-**

__i__**ind” and is defined as the amount of interest expense charged by a lender which accrues towards the ending debt balance (principal).**

__K__Opting for PIK helps the borrower conserve cash since the interest payments are pushed back to a later date. Or in the case of preferred equity, the payout of cash dividends could be deferred for a set, agreed-upon duration.

The downside to the accrued interest, however, is that the total debt principal increases each year until maturity. In effect, this increases the interest expense due to growth in the principal amount.

With each passing period, the amount of accrued interest due can accumulate quickly due to the effects of compounding interest, which can significantly heighten default risk.

## PIK Accrual: Compounding Interest Expense

PIK interest benefits the borrower by providing the optionality to push back cash interest payments on debt.

In turn, lenders are compensated by the accrual of the periodic interest expense towards the ending balance (i.e. higher principal) until maturity.

The PIK rate also typically accrues at a rate higher than the cash interest rate in lieu of immediate cash compensation.

Each year after the issuance of a PIK security, the interest expense owed is impacted by the following factors:

- Initial Principal Amount
- “Rolled-Up” Interest

Certain debt instruments may come with a partial PIK component. For example, a loan with a 10.0% interest rate and 50.0% PIK component means that half of the interest is going to be paid using cash, while the remaining half is accrued.

## PIK Interest Formula

To calculate the paid-in-kind interest, the formula consists of the PIK rate being multiplied by the beginning balance of the applicable debt security or preferred equity.

**PIK Interest =**PIK Interest Rate (%)

**x**Beginning of Period Balance of PIK Debt

Note that if there are mandatory repayments (i.e. principal amortization) associated with the debt, the formula must account for the repaid debt.

This would reduce the interest expense due and the end-of-period debt balance.

Whether the interest expense is paid in cash or PIK, the debt principal and the accrued interest payments must be paid by maturity at the end of the borrowing term, per the lending agreement.

## How to Model the PIK Toggle Switch (Optional)

Often, debt comes arranged with a fixed PIK schedule outlined in the lending agreement.

But another form of PIK interest is referred to as a PIK toggle, which is an agreement between the issuer and borrower that provides the borrower with the option to defer an interest payment if needed.

Based on the liquidity needs of the borrower (i.e. cash on hand) or other conditional provisions, this feature lets a borrower reduce its cash outflows.

If a PIK toggle is in place, the decision on whether interest expense is paid-in-cash or PIK becomes more of a discretionary decision made on the specific circumstances regarding the credit health of the borrower.

PIK interest can be especially attractive to borrowers that are looking to avoid having to incur interest payments to conserve cash (i.e., leveraged buyouts).

In addition, companies that have found themselves in poor financial conditions and in need of debt restructuring can seek to renegotiate debt terms to include the option for PIK.