Hervé BOISMERY

Chapter 8 -

PROVIDING LOANS TO CONSUMERS AND BUSINESSES

1- INTRODUCTION

Just as consumer borrowing has become a key driving force in the financial market-place today, so have lenders choosing to
make these loans.

Bankers have emerged in recent decades to become dominant providers of credit to individual and families, aggressively
advertising their services through “money shops”, “money stores”, and other enticing sales vehicles. The modern
dominance of banks in lending to households stems from their growing reliance on individuals and families for their source
of funds- checkable and savings deposits. Many households today would be hesitant to deposit their money in a bank
unless they believed there was a good chance they would also be able to borrow from that same institution when they
needed a loan. Then, too, recent research suggests that the 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 because the
financial conditions of individuals and families can change quickly due to illness, loss of employment or other family’s
tragedies. The great credit crisis beginning in 2007 has demonstrated how many consumer loans (sometimes millions) can
go bad due to poor lending decisions, bringing on a major recession in the economy. Lending to households, therefore,
must be managed with care and sensitivity to the special challenges they represent. Moreover, profit margins on many
consumer loans have narrowed appreciably in the context of the crisis.

In this chapter, we examine the types of consumer and real-estate-centered loans lenders typically made and see how they
evaluate household loan customers. We also examine the pricing of consumer and real estate loans in financial services
marketplace, considering the pricing consumer modalities.

2) TYPES OF LOANS GRANTED TO INDIVIDUALS AND FAMILIES

Several types of consumer loans are available, and the number of credit plans to accommodate consumers’ financial needs
has been growing in the lake of deregulation and openness especially in Vietnam.

We can classify consumer loans by purpose – what the borrowed funds will be used for – or by type – for example, whether
the borrower must repay in installments or repay in one lump sum when the loan comes due. The most relevant
classification for consumer loans combines both loan types and loan purposes.

For example, loans to individuals and families may be divided into two groups, depending upon whether they finance the
purchase of news with a residential loan (such as a home mortgage or home equity loan) or whether they finance other,
non housing consumer activities through nonresidential loans. Within the non residential category, consumer loans are
often divided into subcategories based on type of loan: installment loans (such as auto or education loans); non installment
loans (such as a cash advance); and revolving credit loans (including credit-card loans).

We will look at the nature of these consumer loans more closely in subsequent sections of this chapter.

2.1- Residential Loans

Credit to finance the purchase of a home or funds improvements on a private residence comes under the label of
residential mortgage loans. The purchase of residential property in the form of houses and multifamily dwellings (including
duplexes and apartment buildings) usually give rise to a long-term loan, typically bearing a term of 15 to 30 years and
secured by the property itself. Such loans may carry either a fixed interest rate or a variable (floating) interest rate that
changes periodically with a specified base rate (such as the market yield on government bonds) or a national mortgage
interest rate. A commitment fee, typically 1 to 2 % of the face amount of the loan, is routinely charged up front to assure
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the borrower that a residential loan will be available for a stipulated period. Although banks are the leading residential
mortgage lenders today, several other important lenders in this market include savings associations, credit unions, finance
companies, and insurance companies as well as the mortgage banking subsidiaries of financial holding companies.

2.2- Nonresidential Loans

In contrast to residential mortgage loans, nonresidential loans to individuals and families include installment loans and non
installment (or single-payment) loans and a hybrid form of credit extended through credit cards (usually called revolving
credit).

2.2.1- Installment Loans

Short-term to medium-term loans, repayable in two or more consecutive payments (usually monthly or quarterly) are
known as installment loans. Such loans are frequently employed to buy big-ticket items (e.g., automobiles, furniture and
home appliances) ort o consolidate existing household debts.

2.2.2- Non installment Loans

Short-term loans individuals and families draw upon for immediate cash needs that are repayable in a lump sum are known
as non installment loans. Such loans may be for relatively small amounts- for example, $ 500 or $ 1,000 – and include
charge accounts that often require payment in 30 days or some other relatively short time period. Non installment loans
may also be made for a short period (usually six months or less) to wealthier individuals and can be quite large, often
ranging from $ 5,000 to $ 50,000 or more. Non installment credit is frequently used to cover the cost of medical care, the
purchase of home appliances, auto and home repairs or cost of vacations.

2.3- Credit Card Loans and Revolving Credit

One of the most popular forms of consumer credit today is accessed via credit cards issued by VISA, Mastercard, Discover,
and many smaller cards companies. Credit cards offer their holders access to either installment or non installment credit
because the customer can charge a purchase on the account represented by the card and pay off the charge in one billing
period, escaping any finance charge, or choose to pay off the purchase price gradually, incurring a monthly finance charge
based on an annual interest rate usually ranging from about 8 % to 24 % and sometimes more. Today, approximately, two-
thirds of all credit cards have variable rates of interest.

Card companies find that installment users of credit cards are far more profitable due to the interest income they generate
than are non installment users, who quickly pay off their charges before interest can be assessed. Cards providers also learn
discount fees (usually 1 to 7 % of credit card sales) from merchants who accept their cards. So rapid has been the
acceptance of charge credit cards that close to trillion are estimated to be in use today in the United States and at least that
many more around the rest of the world.

Credit cards offer convenience and a revolving line of credit the customer can access whenever the need arises. Card
providers have found, however, that careful management and control of their card programs is vital due to relatively high
proportion of delinquent borrowers and the large number of cards that are stolen and used fraudulently. There is evidence
that significant economies of scale pervade the credit card field because, in general, only the largest card operations are
consistently profitable. Nevertheless, credit card programs may survive for a considerable future period because of
advancing technology that gives some cardholders access to a full range of financial services, including savings and
payments accounts.

3) REAL ESTATE LOANS

There are two forms of loans to buy a home:

1) Fixed Interest Rate that the borrower could rely upon.

2) The pressure of inflation and more volatile interest rates rise to adjustable-rate mortgages (ARMs)
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For instance, in USA, these flexible-rate loans amount to about a third of new home loans granted each year. In Vietnam,
more than 85 % of home loans granted each year are flexible loan rates.

The popularity of ARMs may be attributed to aggressive marketing of these loans by lenders seeking to make the yields on
their earning assets more responsive to interest rate movements. Many lending institutions have offered teaser rates
significantly below rate mortgages, they allow more families to qualify for a home mortgage loan. Some home mortgage
lenders have offered cap rates on ARMs. For example, the lender may agree not to raise the loan rate more than two
percentage points in any given year or more than five percentage points over the life of the loan, no matter how high other
interest rates may go.

Whether a customer takes out an FRM or an ARM, the loan officer must determine what the initial loan rate will be and
what the monthly payment will be. Each monthly payment reduces a portion of the principal of the loan and a portion of
the interest owed on the total amount borrowed. With the majority of mortgage loan contracts today, monthly payments
early in the life of the loan go mainly to pay interest. As the loan gets closer to maturity, the monthly payments increasingly
are devoted to reducing the loan’s principal.

3.1- Fixed-Rate Mortgages (FRM)

Loan officers and customers may determine if a mortgage loan is affordable by figuring the required monthly payment given
the interest rate the mortgage lenders proposes to charge. Such problems are applications of the time value of money that
would usually be calculated using a financial calculator or spreadsheet. The formula for monthly payments is:

r /12 ( 1+r /12 )t .12

a (m)= A . t . 12 (4)
( 1+r /12 ) −1
a(m) = customer’s monthly mortgage payment

r = annual loan rate

For example, the required monthly payment for a $ 50,000, 25-year mortgage loan calculated at the fixed rate of 12 % is $
526.61.

300
0.01(1+0.01)
Customer’s monthly payment mortgage = a(m) = $50,000 . = $526.61
(1+ 0.01)300 −1

The total in payments over the life of the loan is $ 526.61 X 25 X 12 = $ 157,983 in interest over the life of the loan. If you
subtract the $ 50,000 in principal, you will find that the borrower will pay $ 107,983 in interest over the life of the loan. The
actual monthly payment normally will vary somewhat from year to year even with a FRM due to changes in property taxes,
insurance and other fees that typically are included in each monthly payment.

3.2- Adjustable-Rate Mortgages

In the foregoing example, we calculated the required monthly payments on a fixed-rate mortgage. We can of course use
the same method to calculate the required monthly payment on an adjustable rate mortgage loan by plugging in a new
interest rate each time interest rates change. For example, assume, as in the previous FRM example, the initial FRM
example, the initial loan for ARM is also 12 %. However, after one year, (i.e. 12 monthly payments) has elapsed, the
mortgage loan rate rises to 13 %. In this case, the customer’s monthly payments would increase to $ 563.30.

( )( )
24 X 12
0 . 13 0 .13
X 1+
12 12
Each Monthly Payment = a(m) = $ 49,662.30 X = $ 563.30

( )
24 X 12
0 . 13
1+ −1
12
This example assumes that the loan rate increased to 13 % beginning with the 13 th monthly payment. Note that after one
year the outstanding principal of the loan (which originally stood at $ 50,000) had dropped to $ 49, 662.30 due to the
monthly payment made during the first 12 months (3). The outstanding principal for the life of a loan can be illustrated
using an amortization table easily prepared using Excel or calculated at a point in time using a financial calculator. When
considering whether to approve a customer’s request for an adjustable-rate loan, the loan officer must decide whether a
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rise in interest rates is likely and whether the customer has sufficient budget flexibility and future earnings potential to
handle the varying loan payments that can exist with an ARM.

4) SOURCES OF SHORT-TERM FINANCING

Business and households obtain short-term loans from several sources: bank loans; commercial paper; cash discount…Let’s
look at some of these alternative sources of short-term financing.

4.1- Loan Interest Rates

The interest rate on a bank loan can be fixed or floating rate, typically based on the prime rate of interest. The prime rate of
interest is the lowest rate of interest charged by leading banks on business loans to their most important business
borrowers. The prime rate fluctuates with changing supply-and-demand relationships for short-term funds. Banks generally
determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the
borrower’s “riskiness”. The premium may amount to 4% or more, although most unsecured short-term loans carry
premiums of less than 2%.

Fixed and Floating Rate Loans: Loans can have either fixed or floating interest rates. On a fixed-rate loan, the rate of
interest is determined at a set increment above the prime rate on the date of the loan and remains unvarying at that fixed
rate until maturity. On a floating-rate loan, the increment above the prime rate is initially established, and the rate of
interest is allowed to “float”, or vary, above prime rate as the prime rate varies until maturity. Generally, the increment
above the prime rate will be lower on floating-rate loan than on fixed-rate loan.

Example:

Megan Schwartz has been approved by Clinton National Bank for 180-day loan of $30,000 that will allow her to make the
down payment and close the loan on her new condo. She needs the funds to bridge the time until the sale of her current
condo, for which she expects to receive $42,000.

The bank offered Megan the following two financing options for the $30,000 loan:

1) A fixed-rate loan at 2% above the prime rate

2) A variable rate loan at 1% above the prime rate.

Currently, the prime rate of interest is 8%, and the consensus forecast of a group of mortgage economists for changes in
the prime rate over the 180 days is as follows:

- 60 days from today the prime rate will rise by 1%.

- 90 days from today the prime rate will rise another 0.50%.
- 150 days from today the prime rate will drop by 1%.

Using the forecast prime rate changes, Megan wishes to determine the lowest interest-cost loan for the next 6 months.

- Fixed-Rate Loan: Total interest cost over 180 days = $30,000 x (0.08 + 0.02) x (180/365) = $30,000 X 0.04932 ≈
$1,480
- Variable-Rate Loan: Total interest cost over 180 days =

$30,000 x

$1,442
[( 0.09 X
60
365)(
+ 0.10 X
30
365 )(
+ 0.105 X
60
365
+(0.095 X
30
365))
] = $30,000 X 0.04808 =

Because the estimated total interest cost on the variable-rate loan of $1,442 is less than the total interest cost of
$1,480 on fixed-rate loan, Megan should take the variable-rate loan.
4.2- Lines of Credit

A line of credit is an agreement between a commercial bank and a client, specifying the amount of unsecured short-term
borrowing the bank will make available to the firm over a given period of time. It is similar to the agreement under which
issuers of bank credit cards, such as MasterCard, Visa and Discover, extend preapproved credit to cardholders. The bank will
allow the borrower to owe it up to a certain amount of money. The amount of a line credit is the maximum amount the
firm can owe the bank at any point time.
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Many short-term bank loans require the borrower to maintain, in checking account, a compensating balance equal to a
certain percentage of the amount borrowed. Banks frequently require compensating balances of 10 to 20%. A
compensating balance raises the interest cost to the borrower.

Example:

Estrada Graphics, a graphic design firm, has borrowed $1 million a line-of credit agreement. It must pay a stated interest
rate of 10% and maintain, in its checking account, a compensating balance equal to 20% of the amount borrowed, or
$200,000. Thus it actually receives the use of only $800,000. To use that amount for a year, the firm pays interest of
$100,000 (0.10 x $1,000,000).

The effective annual rate on the funds is therefore: $100,000/$800,000 = 0.125 = 12.5%

4.3 - Revolving Credit Agreements

A revolving credit agreement is nothing more than a guaranteed line of credit. It is guaranteed in the sense that the
commercial bank assures the borrower that a specified amount of funds will be made available regardless of the scarcity of
money. It is not uncommon for a revolving credit agreement to be for a period greater than one year. Because the bank
guarantees the availability of funds, a commitment fee is normally charged on revolving credit agreement. The fee often
applies to the average unused balance of the borrower’s credit line. It is normally about 0.5% of the average unused
portion of the line.

Example:

REH Company, a major real estate developer, has a $2 million revolving credit agreement with its bank. Its average
borrowing under the agreement for the past year was $1.5 million. The bank charges a commitment fee of 0.5% on the
average unused balance. Because the average unused proportion of the committed funds was $500,000 ($2 million - $1.5
million), the commitment fee for the year was $2,500 ($500,000 x 0.005). Of course, REH also had to pay interest on the
actual $1.5 million borrowed under the agreement. Assuming that $112,500 interest was paid on the $1.5 million borrowed
(corresponding to an interest rate of 7.5%), the effective cost of the agreement was 7.67%:

($112,500 + $2,500)/ $1,500,000 = 0.0767 = 7.67%

Although more expensive than a line of credit, a revolving credit agreement can be less risky from the borrower’s point of
view, because the availability of funds is guaranteed.

4.4 - Discount Interest

The interest rate on a bank loan is often calculated on discount basis. Similarly, when companies issue commercial paper,
they also usually quote the interest rate as a discount. With a discount interest loan, the bank deducts the interest up front.

Example 1:

Suppose that you borrow $100,000 on a discount basis for 1 year at 6%. In this case, the bank hands you $100,000 less 6%,
or $94,000. Then at the end of the year you repay the bank the $100,000 face value of the loan. The effective interest rate
on such a loan is therefore $6,000/$94,000 = 0.0638 = 6.38%.

Example 2:
Suppose that you borrow $100,000 on discount basis for 1 month at 6%. In this case, the bank deducts 0.5% up-front
interest and hands you $99,500. The monthly rate is $500/$99,500 = 0.005025 = 0.5025%.

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We can write: 1 + effective annual rate = (1+0.00525) = 1.0620, which implies an effective annual interest rate of
6.2%.

The general formula for the equivalent compound interest rate on a discount interest loan is:

[ ]
m
1
Effective annual rate on discount loan = quoted annual intest rate -1
1−
m

Where the quoted annual interest rate is stated as a fraction (0.06 in our example) and m is the number of periods in the
year (12 in our example).

Example 3:

Sometimes a supplier will offer a cash discount for early payment. In that case, the purchaser should carefully analyze credit
terms to determine the best time to repay the supplier. The purchaser must weigh the benefits of paying the supplier as
late as possible against the costs of passing up the discount for early payment.

If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no added benefit from
paying earlier than that date.

Lawrence Industries, operator of a small chain of video stores, purchased $1,000 worth of merchandise on February 27
from a supplier extending terms of 2/10 net EOM (end of the month).

It means that the firm must pay ten days after the date of invoice (February 27) and before the end of the month to get a
discount of 2%.

If the firm takes the cash discount, it must pay $980 = $1,000 – (0.02 x $1,000) by March 10, thereby saving $20.

Feb 27------------ March 1----------------------------------------March 10-------------------------------------------------------------March 30-

Firm makes Credit period Cash Discount Period Ends: Credit Period Ends:
$1,000 Purchase begins Pay $980 Pay $1,000

------------------------------------------------------------------------------
Cost of Additional 20 Days = $1,000 - $980 = $20

Another way to say this is that Lawrence Industries’ supplier charges $980 for the goods as long as the bill is paid in 10 days.
If Lawrence takes 20 additional days to pay (by paying on day 30 rather than on day 10), they have to pay the supplier an
additional $20 in “interest”.

Therefore, the interest rate on this transaction is:

2.04% = $20/$980

Keep in mind that the 2.04% interest rate applies to a 20-day loan. To calculate an annualized interest rate, we multiply the
interest rate on this transaction times the number of 20-day periods during a year. The following equation provides the
general expression for calculating the annual percentage cost of giving up a cash discount:
 CD 365
Cost of giving up cash discount = x = (2% /98%) x (365/ 20) = 0.3724 = 37.24%
100 %−CD N
CD = stated cash discount in percentage terms = 2%

N = number of days that payment can be delayed by giving up the cash discount = 20

Example 4:

Occasionally, bank loans require the firm to maintain some amount of money on balance at the bank. This is called a
compensating balance. For example, a firm might have to maintain a balance of 20% of the amount of the loan. In other

words, if the firm borrow $100,000, it gets use only $80,000, because $20,000 (20% of $100,000) must be left on deposit in
the bank.

If the compensating balance does not pay interest (or pays a below-market rate of interest), the actual interest rate on the
loan is higher than the stated rate. The reason is that the borrower must pay interest on the full amount borrowed but has
access to only part of the funds. For example, we calculated above that a firm borrowing $100,000 for a month at 6% simple
interest must pay interest at the end of the month of $500. If the firm gets the use of only $80,000, the effective interest
rate is $500/$80,000 = 0.0625, or 0.625%. This is the equivalent to a compound annual interest rate of (1+0.00625)12 -
1 = 0.0776 or 7.76%.

In general, the compound annual interest rate on a loan with compensating balances is:

[ ]
m
actual interest paid
Effective annual rate on a loan with compensating balances = 1+ -1
borrowed funds available
Where m is the number of periods in the year (again 12 in our example).

Exercise:

Suppose that Dynamic Mattress needs to raise $20 million for 6 months. Bank A quotes a simple interest rate of 7% but
requires that the firm maintain an interest-free compensating balance of 20%. Bank B quotes a simple interest rate of 8%
but does not require any compensating balances. Bank C quotes a discount interest rate of 7.5% and also does not require
compensating balances. What is the effective (or compound) annual rate on each of these loans.