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Unformatted text preview: nstallment loans. The term “add-on” means that the interest is calculated and then added
to the amount received to determine the loan’s face value. To illustrate, suppose you
borrow $10,000 on an add-on basis at a nominal rate of 12 percent to buy a car, with
the loan to be repaid in 12 monthly installments. At a 12 percent add-on rate, you
will pay a total interest charge of $10,000(0.12) $1,200. However, since the loan
is paid off in monthly installments, you have the use of the full $10,000 for only the
first month, and the outstanding balance declines until, during the last month, only
⁄ 12 of the original loan will still be outstanding. Thus, you are paying $1,200 for the
use of only about half the loan’s face amount, as the average usable funds is only
about $5,000. Therefore, we can calculate the approximate annual rate as follows:
Approximate annual rateAdd-on Interest paid
$10,000/2 (27-6) 24.0%. To determine the effective rate of an add-on loan, we proceed as follows:
1. The total amount to be repaid is $10,000 of principal, plus $1,200 of interest, or $11,200.
2. The monthly payment is $11,200/12 $933.33.
3. You are, in effect, paying off a 12-period annuity of $933.33 in order to
receive $10,000 today, so $10,000 is the present value of the annuity. Here is
the time line:
10,000 i=? 1
933.33 2 … 933.33 11 12 Months 933.33 933.33 4. With a financial calculator, enter N
FV 0, and then press I to obtain 1.7880 percent. However, this is a monthly
5. The effective annual rate is found as follows:7
Effective annual rateAdd-on (1 rd)n 1.0 (1.01788)12 1.0
1.2370 1.0 23.7%.
The annual percentage rate (APR), which by law the bank is required to state in
bold print on all “consumer loan” agreements, would be 21.46 percent:
7Note that if an installment loan is paid off ahead of schedule, additional complications arise. For the classic discussion of this point, see Dick Bonker, “The Rule of 78,” Journal of Finance, June 1976, 877–888. 27-22 Chapter 27 Providing and Obtaining Credit APR rate (Periods per year)(Rate per period)
12(1.7880%) 21.46%. Prior to the passage of the truth in lending laws in the 1970s, most banks would
have called this a 12 percent loan, period. The truth in lending laws apply primarily
to consumer as opposed to business loans. Self-Test Questions Name four different ways banks can calculate interest on loans.
What is a compensating balance? What effect does a compensating balance
requirement have on the effective interest rate on a loan? Choosing a Bank
Individuals whose only contact with their bank is through the use of its checking
services generally choose a bank for the convenience of its location and the competitive cost of its services. However, a business that borrows from banks must look
at other criteria and recognize that important differences exist among banks. Some
of these differences are considered next. Willingness to Assume Risks
Banks have different basic policies toward risk. Some follow relatively conservative
lending practices, while others engage in what are properly termed “creative banking
practices.” These policies reflect partly the personalities of bank officers and partly
the characteristics of the bank’s deposit liabilities. Thus, a bank with fluctuating
deposit liabilities in a static community will tend to be a conservative lender, while a
bank whose deposits are growing with little interruption may follow more liberal
credit policies. Similarly, a large bank with broad diversification over geographic
regions and across industries can obtain the benefit of combining and averaging risks.
Thus, marginal credit risks that might be unacceptable to a small or specialized bank
can be pooled by a branch banking system to reduce the overall risk of a group of
marginal accounts.8 Advice and Counsel
Some bank loan officers are active in providing counsel and in granting loans to
firms in their early and formative years. Certain banks have specialized departments
that make loans to firms expected to grow and thus to become more important customers. The personnel of these departments can provide valuable counseling to customers: The bankers’ experience with other firms in growth situations may enable
them to spot, and then to warn their customers about, developing problems. Loyalty to Customers
Banks differ in their support of borrowers in bad times. This characteristic is
referred to as the degree of loyalty of the bank. Some banks may put great pressure
8Bank deposits are insured by a federal agency, and banks are required to pay premiums to cover the cost of this insurance. Logically, riskier banks should pay higher premiums, but to date political forces have limited the use of risk-based
insurance premiums. As an alternative, banks with riskier loan portfolios are required to have more equity capital per
dollar of deposits than less risky banks. The savings and loan industry, until the 1980s, had federal insurance, no differential capital requirements, a...
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