session 9,10,11,12 - addition

Lending to Business Firms and Pricing Business Loans

Key Topics

• Types of Business Loans: Short Term and Long Term

• Analyzing Business Loan Requests

• Collateral and Contingent Liabilities

• Sources and Uses of Business Funds

• Pricing Business Loans

• Customer Profitability Analysis

Introduction

• Securing large amounts of credit that many businesses require can be a challenging task

• Business loans are often called commercial and industrial (C&I) loans▫C&I loans rank among the most important assets banks and their closest

competitors hold

• For U.S. insured commercial banks, close to one-fifth of their loan portfolio is classified as business or C&I loans▫This percentage of the total loan portfolio does not include many commercial

real estate loans and loans to other financial institutions

Brief History of Business Lending

• Commercial and industrial loans represented the earliest form of lending that banks carried out▫Loans extended to ship owners, mining operators, goods manufacturers, and

property owners dominated bankers’ loan portfolios for centuries

• In the late 19th and early 20th centuries new competitors, particularly finance companies, life and property/casualty insurance firms, and some thrift institutions, entered the business lending field▫This placed downward pressure on the profit margins of many business lenders

Types of Business Loans

Short-Term Loans to Business Firms

• Self-Liquidating Inventory Loans▫These loans usually were used to finance the purchase of inventory – raw

materials or finished goods to sell▫Such loans take advantage of the normal cash cycle inside a business firm▫There appears to be less of a need for traditional inventory financing▫Due to the development of just in time (JIT) and supply chain management

techniques

Short-Term Loans to Business Firms (continued)

• Working Capital Loans▫Short-run credit that lasts from a few days to one year▫Secured by accounts receivable or by pledges of inventory▫Carry a floating interest rate▫A commitment fee is charged on the unused portion of the credit line and

sometimes on the entire amount of funds made available▫Compensating deposit balances may be required from the customer▫Recently compensating deposit balances as a part of a business-loan

arrangement has been on the decline


• Interim Construction Financing ▫Secured short-term loan used to support the construction of homes,

apartments, office buildings, shopping centers, and other permanent structures

• Security Dealer Financing▫Dealers in securities need short-term financing to purchase new securities and

carry their existing portfolios of securities until they are sold to customers or reach maturity


• Retailer and Equipment Financing▫Lenders support installment purchases of automobiles, home appliances, and

other durable goods by financing the receivables that dealers selling these goods take on when they write installment contracts to cover customer purchases

• Asset-Based Financing▫Credit secured by the shorter-term assets of a firm that are expected to roll

over into cash in the future

• Syndicated Loans (SNCs)▫A loan package extended to a corporation by a group of lenders

Long-Term Loans to Business Firms

• Term Business Loans▫Designed to fund longer-term business investments, such as the purchase of

equipment or the construction of physical facilities, covering a period longer than one year

• Revolving Credit Financing▫Allows a customer to borrow up to a pre-specified limit, repay all or a portion

of the borrowing, and re-borrow as necessary▫One of the most flexible of all business unsecured loans▫May be short-term or long-term▫Lenders normally charge a loan commitment fee▫Two types: formal loan commitment and confirmed credit line

Long-Term Loans to Business Firms (continued)

• Long-Term Project Loans▫Credit to finance the construction of fixed assets▫Most risky of all business loans▫Some of the risks of project loans:

1. Large amounts of funds are usually involved2. The project may be delayed by weather or shortage of materials3. Laws and regulations in the region where the project lies may change4. Interest rates may change

Long-Term Loans to Business Firms (continued)

• Loans to Support the Acquisition of Other Business Firms – Leveraged Buyouts▫The 1980s and 1990s ushered in an explosion of loans to finance mergers and

acquisitions ▫Leveraged buyouts (LBOs) usually involve acquiring a controlling interest in

another firm with the use of a great deal of debt (leverage) to finance the transaction

Analyzing Business Loan Applications

• Often business loans are of such large denomination that the lending institution itself may be at risk if the loan goes bad

• The most common sources of repayment for business loans are:1. The business borrower’s profits or cash flow2. Business assets pledged as collateral behind the loan3. A strong balance sheet with ample amounts of marketable assets and net

worth4. Guarantees given by the business, such as drawing on the owners’ personal

property to backstop a loan

Analyzing Business Loan Applications (continued)• Analysis of a Business Borrower’s Financial Statements

Financial Ratio Analysis of a Customer’s Financial Statements• Information from balance sheets and income statements is typically

supplemented by financial ratio analysis• Critical areas of potential borrowers loan officers consider:

1. Ability to control expenses2. Operating efficiency in using resources to generate sales3. Marketability of product line4. Coverage that earnings provide over financing cost5. Liquidity position, indicating the availability of ready cash6. Track record of profitability7. Financial leverage (or debt relative to equity capital)8. Contingent liabilities that may give rise to substantial claims in the future

Financial Ratio Analysis of a Customer’s Financial Statements (continued)• The Business Customer’s Control over Expenses

▫A barometer of the quality of a firm’s management is how it controls its expenses and how

well its earnings are likely to be protected and grow

▫ Selected financial ratios to monitor a firm’s expense control:

▫ Wages and salaries/Net sales

▫ Overhead expenses/Net sales

▫ Depreciation expenses/Net sales

▫ Interest expense on borrowed funds/Net sales

▫ Cost of goods sold/Net sales

▫ Selling, administrative, and other expenses/Net sales

▫ Taxes/Net sales

Financial Ratio Analysis of a Customer’s Financial Statements (continued)• Operating Efficiency: Measure of a Business Firm’s Performance Effectiveness

▫ It is also useful to look at a business customer’s operating efficiency

▫How effectively are assets being utilized to generate sales and how

efficiently are sales converted into cash?

▫ Important financial ratios here include:

▫Annual cost of goods sold/Average inventory (or inventory turnover ratio)

▫Net sales/Net fixed assets

▫Net sales/Total assets

▫Net sales/Accounts and notes receivable

Financial Ratio Analysis of a Customer’s Financial Statements (continued)• Operating Efficiency: Measure of a Business Firm’s Performance Effectiveness

• Marketability of the Customer’s Product or Service

▫ In order to generate adequate cash flow to repay a loan, the business customer

must be able to market goods, services, or skills successfully

▫The gross profit margin (GPM), defined as

Financial Ratio Analysis of a Customer’s Financial Statements (continued)• Marketability of the Customer’s Product or Service

▫A closely related and somewhat more refined ratio is the net profit margin

(NPM)

Financial Ratio Analysis of a Customer’s Financial Statements (continued)• Coverage Ratios: Measuring the Adequacy of Earnings

▫Coverage refers to the protection afforded creditors based on the amount of a

business customer’s earnings

▫The best-known coverage ratios include

Financial Ratio Analysis of a Customer’s Financial Statements (continued)• Liquidity Indicators for Business Customers

▫The borrower’s liquidity position reflects his or her ability to raise cash in

timely fashion at reasonable cost, including the ability to meet loan payments

when they come due

Financial Ratio Analysis of a Customer’s Financial Statements (continued)• Profitability Indicators

▫How much net income remains for the owners of a business firm after all

expenses (except dividends) are charged against revenue?

▫Popular bottom line indicators include

▫Before-tax net income / total assets, net worth, or total sales

▫After-tax net income / total assets (or ROA)

▫After-tax net income / net worth (or ROE)

▫After-tax net income / total sales (or ROS) or profit margin

Financial Ratio Analysis of a Customer’s Financial Statements (continued)• The Financial Leverage Factor as a Barometer of a Business Firm’s Capital

Structure▫Any lender is concerned about how much debt a borrower has taken on in

addition to the loan being sought▫Key financial ratios used to analyze any borrowing business’s credit standing

and use of financial leverage include

Comparing a Business Customer’s Performance to the Performance of Its Industry• It is standard practice to compare each business customer’s performance to the

performance of the customer’s entire industry

▫Dun & Bradstreet Industry Norms and Key Business Ratios

▫RMA Annual Statement Studies

Comparing a Business Customer’s Performance to the Performance of Its Industry (continued)• Contingent Liabilities

▫Usually not shown on customer balance sheets are other potential claims against the

borrower:

1. Guarantees and warranties behind the business firm’s products

2. Litigation or pending lawsuits against the firm

3. Unfunded pension liabilities

4. Taxes owed but unpaid

5. Limiting regulations▫ These contingent liabilities can turn into actual claims against the firm’s assets and

earnings at a future date▫ Loan officer must ask the customer about pending or potential claims against the firm

Comparing a Business Customer’s Performance to the Performance of Its Industry (continued)• Contingent Liabilities

▫Environmental Liabilities

▫The Comprehensive Environmental Response, Compensation, and Liability

Act (CERCLA) and its Super Fund Amendments

▫Make current and past owners of contaminated property or of businesses

located on contaminated property and those who dispose of or transport

hazardous substances potentially liable for any cleanup costs associated

with environmental damage

Comparing a Business Customer’s Performance to the Performance of Its Industry (continued)• Contingent Liabilities (continued)

▫Underfunded Pension Liabilities

▫Under Financial Accounting Standards Board (FASB), borrowing customers

may be compelled to record employee pension plan surpluses and deficits on

their balance sheets

▫ If projected pension-plan liabilities exceed expected funds sources, the result

may be an increase in liabilities

Preparing Statements of Cash Flows from Business Financial Statements• The Statement of Cash Flows illustrates how cash receipts and disbursements are

generated by operating, investing, and financing activities

Preparing Statements of Cash Flows from Business Financial Statements (continued)

Pricing Business Loans

• One of the most difficult tasks in lending is deciding how to price a loan▫Lender wants to charge a high enough interest rate to ensure each loan will be

profitable and compensate the lending institution for the risks involved

• The Cost-Plus Loan Pricing Method

Pricing Business Loans (continued)

• The Price Leadership Model


• In the U.S., the prevailing prime rate is considered to be the most common base rate

• Two different floating prime rate formulas were soon developed by leading money center banks▫Prime-plus method▫Times-prime method

• London Interbank Offered Rate (LIBOR)▫Leading commercial lenders have switched to LIBOR-based loan pricing due

to the growing use of Eurocurrencies as a source of loanable funds▫LIBOR-based loan rate = LIBOR + Default-risk premium + Profit margin


• Below-Prime Market Pricing▫Banks announced that some large corporate loans covering only a few days or

weeks would be made at low money market interest rates▫Federal funds rate on domestic loans plus a small margin


• Customer Profitability Analysis (CPA)▫New loan pricing technique that is similar to the cost-plus loan pricing

technique▫Assumes that the lender should take the whole customer relationship into

account when pricing a loan


• Customer Profitability Analysis (CPA)

▫ If the net rate of return is positive, the proposed loan is acceptable because all expenses have been met

▫ If the net rate of return is negative, the proposed loan and other services provided to the customer are not correctly priced as far as the lender is concerned

▫The greater the perceived risk of the loan, the higher the net rate of return the lender should require


• Customer Profitability Analysis (CPA) ▫Earnings Credit for Customer Deposits▫ In calculating how much in revenues a customer generates for a lending

institution, many lenders give the customer credit for any earnings received from investing the balance in the customer’s deposit account

Consumer Loans, Credit Cards, and Real Estate Lending

Introduction

• Consumer debt has become one of the fastest growing forms of borrowing money▫Nearly $14 trillion in volume (including both mortgage and nonmortgage

consumer debt) in the U.S.

• The modern dominance of banks in lending to households stems from their growing reliance on individuals and families for their chief source of funds – checkable and savings deposits

• Consumer credit is often among the most profitable services a lender can offer▫However, services directed at consumers can also be among the most costly

and risky financial products

Types of Loans Granted to Individuals and Families• Consumer loans are classified by▫Purpose – what the borrowed funds will be used for▫Type – whether the borrower must repay in installments or repay in one lump sum

• Residential Loans ▫Credit to finance the purchase of a home or fund improvements on a private

residence▫Usually a long-term loan, typically bearing a term of 15 to 30 years▫Secured by the property itself▫May carry either a fixed interest rate or a variable (floating) interest rate▫Banks are the leading residential mortgage lenders today

Types of Loans Granted to Individuals and Families (continued)• Nonresidential Loans ▫ Installment Loans ▫Short-term to medium-term loans, repayable in two or more consecutive

payments (usually monthly or quarterly)▫Used to buy big-ticket items (e.g., automobiles, furniture, and home appliances)

or to consolidate existing household debts▫Noninstallment Loans ▫Short-term loans individuals and families draw upon for immediate cash needs

that are repayable in a lump sum▫May be for relatively small amounts and include charge accounts that often

require payment in 30 days or less▫May also be made for a short period (usually six months or less) to wealthier

individuals and can be quite large

Types of Loans Granted to Individuals and Families (continued)• Credit Card Loans and Revolving Credit ▫One of the most popular forms of consumer credit today is accessed via credit

cards▫Credit cards offer their holders access to either installment or noninstallment

credit▫Approximately two-thirds of all credit cards have variable rates of interest▫ Installment users of credit cards are far more profitable due to the interest

income they generate▫Card providers also earn discount fees (usually 1 to 7 percent of credit card

sales) from merchants who accept their cards

Types of Loans Granted to Individuals and Families (continued)• New Credit Card Regulations ▫New credit card regulations appeared early in 2003 to slow the expansion of

card offers to customers with low credit ratings▫There was evidence that some customers were charged high fees but

encouraged to make only low minimum payments▫Resulted in negative amortization

▫Regulatory agencies warned lenders that federal examiners would begin looking for excessive use of fees and unreasonably liberal credit terms

Types of Loans Granted to Individuals and Families (continued)• New Consumer Regulations: Dodd-Frank, CARD Act, and the New Consumer

Protection Bureau▫Tricks and Traps – The CARD Act and Revised Regulation Z Appear▫Despite the repeated efforts of credit card regulators to deal with problems

in the credit card industry, consumer complaints continued▫Congress passed the Credit Card Accountability, Responsibility, and

Disclosure Act (“CARD Act”) in May 2009▫The new legislation restricted card issuers from raising Annual Percentage

Rates (APRs) unless adequate written notice of a rate change was given

Types of Loans Granted to Individuals and Families (continued)• New Consumer Regulations: Dodd-Frank, CARD Act, and the New Consumer

Protection Bureau ▫ Tricks and Traps – The CARD Act and Revised Regulation Z Appear

▫Customers must be told the reasons why credit terms were being changed▫Card companies are required to post their contracts on the Internet so

customers can “shop around”▫Card holders must receive periodic billing statements at least three weeks

before monthly payments are due▫An expanded “box” must be included on each monthly billing statement,

indicating the amount of interest paid and the consequences of paying the minimum amount

▫Fall within the Federal Reserve Board’s Regulation Z

Types of Loans Granted to Individuals and Families (continued)• Dodd-Frank Reforms and Protections Push the Rules Farther Down the Road▫ The Dodd-Frank Wall Street Reform and Consumer Protection Act ▫Named after Senator Chris Dodd and Congressman Barney Frank▫Was signed into law by President Obama in July 2010▫ Creates the Consumer Financial Protection Bureau (CFPB)▫ The new bureau is directed to write new rules applying to such financial services as:▫Making of consumer and credit card loans▫Warning consumers of possible damaging financial practices that could result in

losses▫ Promoting financial literacy among consumers▫ Improving the clarity and transparency of financial-service contracts for the benefit

of the public

Types of Loans Granted to Individuals and Families (continued)• Dodd-Frank Reforms and Protections Push the Rules Farther Down the Road ▫The Dodd-Frank Wall Street Reform and Consumer Protection Act ▫The new CFPB is to be housed within the Federal Reserve but operate

independently with its own budget▫The consumer protection bureau is expected to be controversial because it

must write hundreds of rules that will likely impact the consumer services side of financial-service providers

Characteristics of Consumer Loans

• Lenders regard consumer loans as profitable credits with “sticky” interest rates▫Contract interest rates often do not change readily with market conditions as

do interest rates on most business loans▫As a result, many consumer loans are subject to significant interest rate risk

• Consumer loans are usually priced so high that market interest rates on borrowed funds and default rates on the loans themselves would have to rise substantially before consumer credits would become unprofitable

Characteristics of Consumer Loans (continued)

• Why are interest rates so high on most consumer loans?▫Consumer loans are among the most costly and most risky to make per dollar

of loanable funds committed to them▫Consumer loans tend to be cyclically sensitive▫Household borrowings appear to relatively interest inelastic▫They are more concerned about the size of the monthly payment rather than

the interest rate that they are charged▫Education and income levels materially influence consumers’ use of credit

Evaluating a Consumer Loan Application

• Character and Purpose▫Key factors in analyzing any consumer loan application are the character of

the borrower and the borrower’s ability to pay▫Consumer lenders nearly always check with one or more credit bureaus

concerning the customer’s credit history▫ In the case of a borrower without a credit record or with a poor track record of

repaying loans, a cosigner may be requested to support repayment▫Many lenders regard a cosigner as primarily a psychological device to

encourage repayment of the loan

Evaluating a Consumer Loan Application (continued)• Other Important Items For Lenders • Income Levels• Deposit Balances• Employment and Residential Stability• Pyramiding of Debt

• How to Qualify for a Consumer Loan• Home ownership or ownership of any form of real property• Maintain strong deposit balances• The most important thing to do – truthfully answer all of the loan officer’s

questions

Credit Scoring Consumer Loan Application

• The basic theory of credit scoring is that lenders and statisticians can identify the financial, economic, and motivational factors that separate good loans from bad loans

• Underlying assumption – the same factors that separated good loans from bad loans in the past will separate good loans from bad ones in the future within an acceptable risk of error

• Such an automated credit determining system removes personal judgment from the lending process

Credit Scoring Consumer Loan Application (continued)• The FICO System▫Developed by the Fair Isaac Corporation▫Most famous of all credit-scoring systems currently in use▫ Scores range from 300 to 850 with higher values denoting less credit risk to lenders▫ FICO score are based on five different types of information (most important to least

important):

1. The borrower’s payment history

2. The amount of money owed

3. The length of a prospective borrower’s credit history

4. The nature of new credit being requested

5. The types of credit that the borrower has already used

Laws and Regulations Applying to Consumer Loans• Numerous laws and regulations limiting the activities of consumer lending

institutions have been enacted

• These laws fall into two categories:1. Disclosure rules▫Mandate telling the consumer about the cost and other terms of a loan or

lease agreement

2. Antidiscrimination laws▫Prevent categorizing loan customers according to their age, sex, race, or

other irrelevant factors and denying credit to anyone solely because of membership in one or more of these groups

Laws and Regulations Applying to Consumer Loans (continued)• Customer Disclosure Requirements • Truth-in-Lending Act• Fair Credit Reporting Act• Fair Credit Billing Act• Fair Debt Collection Practices Act

• Outlawing Credit Discrimination• Equal Credit Opportunity Act• Community Reinvestment Act

Laws and Regulations Applying to Consumer Loans (continued)• Predatory lending ▫An abusive practice among some lenders where lenders may require excessive

fees as well as unnecessary and excessive loan insurance

• Subprime Loans▫Granting loans to borrowers who have below-average credit scores

• The Home Ownership and Equity Protection Act was passed in 1994 to protect home buyers from loan agreements they could not afford

• Subprime lending is difficult to regulate

Real Estate Loans

• Depository institutions and finance and insurance companies make real estate loans to fund the acquisition of real property▫Homes, apartment complexes, shopping centers, office buildings, and land

• One of the most rapidly growing areas of lending over the past decade

• Real estate lending is different from other loans

• Real estate loans can be among the riskiest forms of credit extended to customers

Real Estate Loans (continued)

• Differences between Real Estate Loans and Other Loans▫The average size of a real estate loan is usually much larger than the average

size of other loans

▫Mortgage loans tend to have longer maturities versus other types of loans ▫Maturities of 15 years to 30 years are typical for single-family homes

▫With real estate lending, the condition and value of the subject property are nearly as important as the borrower’s income▫Appraisals are critical to the loan decision and must meet industry standards

and government regulations


• Factors in Evaluating Applications for Real Estate Loans▫The amount of the down payment pledged by the borrower relative to the

purchase price of mortgaged property▫The higher the ratio of loan amount to purchase price, the less incentive the

borrower has to honor the terms of the loan▫Lenders may be willing to give a mortgage loan customer a lower loan rate for

a pledge that the customer will use the lender’s other financial services


• Factors in Evaluating Applications for Real Estate Loans ▫Other aspects of each credit application that require assessment:▫Amount and stability of the borrower’s income▫The borrower’s available savings and where the borrower will obtain the

required down payment▫The borrower’s track record in caring for and managing property▫The outlook for real estate sales in the local market in case of repossession

of the property▫The outlook for market interest rates


• Home Equity Lending▫Homeowners can borrow the equity in their homes▫Equity is defined as the difference between a home’s estimated market value

and the amount of the mortgage loans against it▫Two main types of home equity loans:

1. Traditional Home Equity Loan2. Lines of Credit Against a Home’s Borrowing Base


• The Most Controversial of Home Mortgage Loans: Interest-Only and Adjustable Mortgages and the Recent Mortgage Crisis

▫When housing prices were soaring upward during the recent housing boom, how could lenders make extravagantly priced homes affordable?▫Make home mortgage loans more readily available to families of even

modest means

▫More families were encouraged to sign up for adjustable-rate loans (ARMs) during a period when market interest rates were at historic lows


• The Most Controversial of Home Mortgage Loans: Interest-Only and Adjustable Mortgages and the Recent Mortgage Crisis ▫When home prices continued to rise, clever mortgage lenders came up with yet

another financial innovation – the interest-only adjustable home mortgage loan (option ARM)▫With this type of credit the home buyer is obligated to pay only the interest

on his or her home loan for an initial period▫After that initial time interval passes, the home buyer would have to pay

both principal and interest until the loan was finally paid off▫Looked like predatory lending against lower-income families▫ In an environment of rising market interest rates, many home buyers with

adjustable-rate loans faced higher interest payments


• The Most Controversial of Home Mortgage Loans: Interest-Only and Adjustable Mortgages and the Recent Mortgage Crisis ▫Now lenders must disclose more about the actual terms of a home mortgage

loan and not represent a loan’s terms as “fixed” when those terms can be changed over time

▫Dodd-Frank Wall Street Reform and Consumer Protection Act resulted in tough new rules▫Lenders who are pooling and securitizing mortgage loans they create and

sell are responsible for at least 5 percent of the credit risk attached (qualified mortgages are exempt)

▫Previously lenders “washed their hands” of any responsibility

A Revised Federal Bankruptcy Code as Bankruptcy Filings Soar• Households in record numbers have sought protection from their creditors under

the U.S. bankruptcy code

• Bankruptcy Abuse Prevention and Consumer Protection Act▫Signed in April 2005 by President George W. Bush ▫Made filing for bankruptcy more expensive and time-consuming▫Before filing for bankruptcy, applicants must complete a certified credit

counseling program▫ Intended to discourage consumers from taking on too much debt and

increasing their risk profile

A Revised Federal Bankruptcy Code as Bankruptcy Filings Soar (continued)• A means test determines whether an applicant must file under Chapter 7 or Chapter

13 of the bankruptcy code▫Means Test - an average of a debtor’s past six months of gross income▫Test determines if the debtor has enough income to pay some of the debt

• Under the previous bankruptcy code, most individuals filed for Chapter 7▫Wiped out all or most debts and generally allowed for a fresh start

• Makes it harder for applicants to apply for Chapter 7▫More applicants, as a result must file under Chapter 13▫Stipulates that at least some debts must be repaid

Pricing Consumer and Real Estate Loans: Determining the Rate of Interest and Other Loan Terms

• A financial institution prices every consumer loan by setting an interest rate, maturity, and terms of repayment

• The Interest Rate Attached to Nonresidential Consumer Loans▫ The Cost-Plus Model

Pricing Consumer and Real Estate Loans: Determining the Rate of Interest and Other Loan Terms (continued)

• Annual Percentage Rate (APR)▫Annualized internal rate of return that equates expected total payments with

the amount of the loan▫Takes into account how fast the loan is being repaid and how much credit the

customer will actually have use of during the life of the loan▫Under the Truth-in-Lending Act, lenders must give the household borrower a

statement specifying the APR▫Allows borrowers to compare a particular loan rate with the loan rates of other

lenders


• Simple Interest Rate

▫Adjusts for the length of time a borrower actually has use of credit▫ If the customer is paying off the loan gradually, this approach determines the

declining loan balance, and that reduced balance is then used to determine the amount of interest owed


• The Discount Rate Method▫Requires the customer to pay interest up front▫ Interest is deducted first and the customer receives the loan amount less any

interest owed

• The Add-On Loan Rate Method▫One of the oldest loan rate calculation methods▫Any interest owed is added to the principal amount of the loan before

calculating required installment payments▫Only if the loan is paid off in a single lump sum at the end will the add-on rate

equal the simple interest rate


• Rule of 78s▫A rule of thumb to determine how much interest income a lender is entitled to

accrue at any point in time from a loan that is being paid out in monthly installments

▫ Important especially when a borrower wants to pay off a loan early▫Rule arises from the fact that the sum of the digits 1 through 12 is 78▫To determine the borrowing customer’s interest rebate from early repayment

of an installment loan, total the digits for the months remaining on the loan and divide the sum by 78


• Rule of 78s ▫Example▫A customer requests a one-year loan to be repaid in 12 monthly installments▫Customer would also like to repay the loan after only nine months▫ Interest rebate that the customer is entitled to receive back

▫The lender is entitled to keep 92.31 percent of the finance charges


• Interest Rates on Home Mortgage Loans▫Since the 1930s, most loans to finance the purchase of new homes were fixed-

rate mortgages (FRMs)▫ In 1981, adjustable-rate mortgages (ARMs) were authorized for offering by all

federally chartered depository institutions▫Created in response to the pressure of inflation and volatile interest rates


• Interest Rates on Home Mortgage Loans ▫Whether a customer takes out a FRM or ARM, the loan officer must determine

what the initial loan rate will be and what the monthly payments will be▫The formula to compute monthly mortgage payments is


• Charging the Customer Mortgage Points ▫Home mortgage loan agreements often require borrowers to pay an additional

charge up front called points▫Points are prepaid interest and may be deductible as home mortgage interest▫For example, suppose the borrower seeks a $100,000 home loan and the lender

assesses the borrower an up-front charge of two points

session 9,10,11,12 - addition

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