LENDINGBanking & Finance

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Activity: Small Group Discussion 3 minutes

• What institutions are responsible for making loans?

• How do loans benefit a financial institution?

• What are the risks involved in lending money?

Prepare to share your responses

with the class

Word Study

Loan

Secured Loan

Unsecured Loan

Collateral

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Loans

• Describe the different types of loans.

• Explain the types of financing assistance provided to businesses.

Loan Characteristics

What’s a Loan?• money temporarily

transferred to a borrower in exchange for repayment and interest

• Principal: amount a bank loans to a customer

• Why do individuals and businesses borrow money?

Characteristics• Loan Policy• Consumer and

Commercial• Open and Closed• Secured and Unsecured

Any lending institution must balance the need to make money with the

risk involved.

Loan Policy(followed to keep things in balance)

• Portfolio mix: selecting loans from different sectors

• Rate of interest: interest earned on loans relative to collection costs for the loans

• Risk diversification: balance between safe and risky loans

Certain guidelines are

included in these policies:

Loan Policy(developed by the bank’s loan committee)

• Reviews loan policy on an ongoing basis;• Explores the development of new loan

products;• Looks for trends that will affect profitability

or exposure to risk; and• Makes suggestions for changes to the

policy (once a year)

The first characteristic used to classify loans is based on who borrows the money.

Consumer Loan• When an individual

borrows money for his or her own use.

• Personal, family, household needs

Commercial Loan• When a company

borrows money.• Equipment, machinery, or

inventory

Overview of Commercial Loan ProductsType of Loan Uses

Acquisition Purchase property or another company

Acquisition and development Purchase and improve property

Asset-based For any reason; collateral is held

Bridge Temporary funds to use before long-term financing is acquired

Construction Building things such as factories, retail stores, and office buildings

Construction improvement and rehab

Purchase an existing property that is then repaired and/or remodeled

Development Property developers improve a property, such as adding new houses to a subdivision

Refinancing Pay off debt

Small Business Administration (SBA)

Help small businesses get started

The second characteristic used to classify loans is based on repayment of the loan.

Open-ended Loan• Does not have to be paid

in full by a specific date• Example: credit card

Closed-end loan• Must be paid in full on a

specific date• Example: installment

loan (for a large amount of money, repaid in smaller amounts over specified period of time)

Security means safety.

Secured Loan• Backed by borrower’s

property (collateral)• Example: car loan

Unsecured Loan• Not backed by collateral• aka signature loan• Why?• Interest rate usually

higher• Payment late? Add’l fees

applied.• Bank can sue borrower

Financial Assistance to Businesses

Small Business Administration (SBA)• Created in 1953 as an

independent agency of the federal gov’t

• Purpose to help Americans start and grow businesses

• Much help in form of loans

Export-Import Bank of the United States• Ex-Im Bank• Helps businesses export

American goods and services to foreign countries

• Created by presidential decree in 1934

• Changes due to increased globalization

Financial Assistance to Businesses

Farm Service Agency (FSA)• Provides financial and

logistical support to commercial farms

• Part of US Department of Agriculture (USDA)

• Makes loans and provides guaranties for others

• USDA does not make loans, but makes grants

World Bank Group (WBG)

• Loans and grants easing poverty around the world

Checkpoint 8.11. What is a lending institution

balancing when it makes a loan? Name 2 things.

2. List the types of commercial loans.

3. A credit card is considered what type of loan? Why?

4. Why is collateral important to the bank when granting a loan to customers?

5. Why is an unsecured loan also known as a signature loan?

Bellringer

Word Study

Equity

Mortgage

Activity

• Make a list of things that affect the interest rate of a loan.

• Prepare to share your ideas with the class.

Real Estate Loans

• Describe the characteristics of a mortgage loan.

• Explain a home-equity loan.

Mortgage Loans

• Real estate: section of land, air above it, ground itself, and any buildings on the land

• Mortgage loan: made to purchase real estate

• Secured loan. Why?

Government-Backed Mortgage Programs

• Federal Housing Administration (FHA) guarantees home loans with down payments of 3% or less.

• Veteran’s Administration (VA) provides loan guarantees to lenders that make loans to qualifying veterans.

• Ginnie Mae (gov’t-owned corporation that backs loans made by FHA and VA) puts together a group of FHA loans

• Sells bonds guaranteed by US gov’t (mortgage-backed securities—MBSs)

Government-Backed Mortgage Programs

• Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs)

• public interest is in increasing homeownership and affordable rental housing

• Chartered and supported by the gov’t to promote a public interest

• Publicly traded. . . Meaning what?• Not backed by government

Nature of Mortgage Loans

• Mortgage Interest Rates– Fixed-rate: rate stays the same for

entire term of loan– Adjustable-rate (ARM): rate may

change over the life of loan• Look for a cap: identifies max increase

that can apply

– Term: number of years loan will exist• 15 and 30-year

– Closing costs: fees applied when mortgage is signed.

Nature of Mortgage Loans

Loan Term Number of Payments

Payment per Month

Interest Paid Over the Course of the loan

15 years 180 $1,581.59 $84,686.20

30 years 360 $1,073.64 $186,510.40

Comparing Loan Terms for a $200,000 Mortgage at 5% Interest.

Activity

• Go to Autotrader.com• Perform the same formula on previous

slide to the car you would like to purchase• Calculate the difference between a 2- and

a 6-year loan on the car• Submit.

Bellringer

• Why is the interest rate for an unsecured loan often higher than the interest rate for a secure loan?

Applying for a Mortgage

• Potential buyer must have finances in order

• Fill out mortgage application• Provide info and supporting documents• Lender will order credit report• Lender provides good faith estimate• Loan goes to underwriter (approval or

denial)

Mortgage-Related Laws

• Real estate taxes and homeowners insurance must be held in an escrow account set up by the lender.

• Escrow account: account in the name of the borrower and is separate from the mortgage account.

• Buyers who finance more than 80% are required to pay private mortgage insurance (PMI)

• PMI: insurance policy that pays the lender if the borrower defaults

Small Group Activity

In your group, perform research on the following mortgage-related laws:

• Jacks: Truth-in-Lending Act• Queens: Community Reinvestment Act• Kings: Home Mortgage Disclosure Act• Aces: Equal Credit Opportunity Act

Each group member must report 1 fact on the assigned act.

Bellringer

• Explain the difference between a fixed rate mortgage and an adjustable rate mortgage.

Equity Loans

• Equity: difference between the real estate’s value and the amount owed for the real estate

• Belongs to the owner• If owner sells, they pay off the loan first.• Amount of money left is the equity• Equity loan: temporarily transfers cash to the

borrower

Real Estate Value $200,000

MortgageEquity

Relationship Between Equity and Value

Equity Loan (second mortgage) Characteristics• Consumer and Commercial

– Consumer: pay off credit cards, improve real estate, or pay education costs

– Commercial: purchase add’l equipment or inventory, repair or improve equipment, or expand the business

• Interest Rates– Higher than a mortgage interest rate

• Same property being used to secure 2 loans• 1st loan (mortgage) paid before 2nd loan (equity loan)

• Term and Fees– 5 to 30 years

Checkpoint 8.2

1. Why is a mortgage a secured loan?

2. What public interest are Fannie Mae and Freddie Mac chartered to promote?

3. How does a fixed rate loan benefit the lender?

4. How do you calculate the owner’s equity if he or she has a mortgage loan?

5. Why would a consumer use a home-equity loan to pay off credit card debt?

Granting Loans

• Describe the five C’s of credit• Explain how commercial loans are evaluated• Describe the steps in applying for a loan

Paired Activity

• Break up into pairs. • Role-play a customer applying for a loan,

with one person acting as the loan officer, and the other person acting as the individual trying to apply for a loan.

• Prepare to report.

Word Study

Predatory Lending

Individual Activity

• Research the factors that negatively affect an individual’s credit score.

• What things should students refrain from doing if they want a good credit score?

• Do any of these things matter more than the others?

Creditworthiness(assessment of a borrower’s ability to repay a loan)

Credit Scores

• Measure of risk based on the borrower’s credit history• Risk: likelihood of financial loss caused by a borrower

failing to repay the principal and interest specified in a loan

• Higher is better• Credit bureau: company that gathers, analyzes, and

summarizes credit-related info on consumers– Equifax, Experian, and TransUnion– Free report every 12 months– FICO score: credit rating used by lenders to predict

applicant’s ability to repay• Ranges from 300-850

35%

30%

15%

10%

10%FICO Score Elements

Payment history: Are payments late? If payments are late, ow late are they? How recently was a payment late? How many payments are currently late?

Amount owed: How many accounts have a current balance? How much is owed on each account?

Length of credit history: How long has each account been established? How recently was each account active?

New credit: How many accounts have been opened recently? Have other potential lenders checked the FICO score recently?

Types of credit used: What types of accounts does the applicant have? Loans? Morgages? Credit cards?

Credit for Commercial Loans

To assess the risk involved with commercial loans, lenders look at the company or organization’s balance sheet, cash flow, and collateral.

• Commercial debt ratios are another factor in determining approval

• Debt ratios compare debt to income or assets

Commercial Debt RatiosRatio Equation Definition Example

Debt Debt / incomeorLiability / assets

Compares what is owed to what is owned

[$100,000/$500,000] X 100 = Ratio of 20%

Debt Service coverage

Debt payment / income

Compares the amount needed to pay on a debt rather than the whole debt with income

[$2,500/$750,000] X 100 = Ratio of 50%

Loan-to-value

Mortgage amount / appraised value of property

Compares the amount financed to the value of a given property. It relates to equity

[$250,000/$750,000] X 100 = Ratio of 33%

Credit-Application Process

Applying

Docu-menting

Submitting

Under-writing

Approval

Closing Funding

Bellringer

If a home’s value is $150,000 and the balance of the mortgage loan is $80,000, how much equity does the owner have?

Subprime Loans

• Loan with fees and interest rates that are higher than the rates given to a person who meets all of the underwriting criteria

• The Crisis of Credit Visualized

Checkpoint 8.31. List the five C’s of credit.

2. What are the three things that would show an applicant has good character?

3. How does a FICO score affect a loan application?

4. When considering the risk posed by a commercial loan, what three things do lenders look at?

5. Why would an applicant ask someone to cosign a loan application?

Profits and Losses

• Distinguish between a loan’s nominal annual rate, annual percentage rate, and periodic rate.

• Use three methods to calculate finance charges.

• Describe how bankruptcy affects lenders.

Interest Rates

Lenders are required to disclose the nominal rate, annual percentage rate (APR), and the periodic rate for every loan made

• Nominal annual rate: identifies loan’s annual interest rate w/out cost of fees or compound interest

• Annual percentage rate (APR): annual cost of a loan, including all interest

• Periodic interest rate: interest rate the lender applies to a loan’s outstanding balance to calculate finance charge each billing period.

Calculating Finance Charges

• Each month, most credit cardholders pay a finance charge

• Cost of carrying the debt

• Includes interest and fees– Transaction fees– Account-maintenance

fees– Late fees

Calculating Finance Charges

1. Average daily balance method: uses the card’s beginning daily balance (most common)

2. Previous balance method: uses the amount the customer owed at the end of the previous billing period to calculate the interest owed for the current month

3. Adjusted balance method: uses the balance from the previous month and subtracting payments made during the current period (most favorable)

Calculating Finance Charges:Average Daily Balance Method

Step 1: Subtract any payments made to the account the day from the beginning balance.

$381.90 (balance) - $20.00 (payment) = $361.90

Step 2: Total the daily balances for the billing period.

$361.90 (balance on day 1) + $11,049.58 (sum of balances for each of the following 29 days) = $11,411.48

Step 3: Divide the total by the number of days in the billing period to give the average daily balance.

$11,411.48 (total of daily balances)/30 (days in the billing period) = $380.38 (average daily balance)

Step 4: Multiply the average daily balance by the annual percentage rate multiplied by the number of days in the billing cycle and divide by the number of days in the year.

$380.38 (average daily balance) x 12% (12% annual percentage rate) x 30 (number of days in the billing cycle)/ 365 = $3.75 (finance charges)

Calculating Finance Charges:Previous Balance Method

Multiply the balance a the end of the previous billing period by the periodic interest rate

$381.90 (previous month’s balance) x .01% (periodic interest rate: 12% APR / 12 months) = $3.82

Calculating Finance Charges:Adjusted Balance Method

Step 1: Total the payments made in the current period.

$20 (payment made on day 5 of the billing cycle) + $50 (payment made on day 25 of the billing cycle) = $75

Step 2: Subtract the result from the previous month’s balance.

$381.90 (previous month’s balance) - $75 (total of payments made) = $306.90

Step 3: Multiply the result by the periodic interest rate to get the finance charges..

$306.90 x .01% (periodic interest rate: 12% APR / 12 months) = $3.08

Loans in Default

• Borrower’s failure to meet the terms of a loan agreement– Failure to make

payment when due

• lender can sue, take possession

• Expenses involved. Like what?

Bankruptcy

• A legal procedure that enables individuals or companies to eliminate or repay some or all debt under the guidance of federal bankruptcy courts

• 2nd chance• On credit record for

10 years

Bankruptcy

Liquidation• Process of converting

property into cash• Chapter 7: releases from

person responsibility of debt– Property sold and funds

given to lenders

Reorganization• Process of creating a

repayment plan to repay debts without liquidating property (businesses can do this too)

• Chapter 11: company• Chapter 13: individual

Checkpoint 8.41. What is the difference between the

nominal annual rate and the APR?

2. What is the most common method used to calculate finance charges?

3. Which method used to calculate finance charges is the most favorable for borrowers?

4. What is the most common reason for loans to go into default?

5. Why is liquidation a possibility when dealing with bankruptcy?

Individual Activity

• Using the Internet, find at least 3 news broadcasts and 3 articles about the controversy surrounding Fannie Mae and Freddie Mac. (provide URLs)

• Write a 1-page report in which you discuss the purposes and responsibilities of these entities, and how they were fundamentally changed during the Great Recession of the 21st century.