These filings prevent the borrower from using the

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Unformatted text preview: oans from different lenders, and they spell out conditions under which the lender can seize the collateral. 3. Loan guarantees. If the borrower is a small corporation, its bank will probably insist that the larger stockholders personally guarantee the loan. Banks have often seen a troubled company’s owner divert assets from the company to some other entity he or she owned, so banks protect themselves by insisting on personal guarantees. However, stockholder guarantees are virtually impossible to get in the case of larger corporations that have many stockholders. Also, guarantees are unnecessary for proprietorships or partnerships because here the owners are already personally liable for the business’s debts. 4. Nominal, or stated, interest rate. The interest rate can be either fixed or floating. If it floats, it is generally indexed to the bank’s prime rate, to the T-bill rate, or to the London Inter-Bank Offer Rate (LIBOR). Most loans of any size ($25,000 and up) have floating rates if their maturities are greater than 90 days. The note will also indicate whether the bank uses a 360- or 365-day year for purposes of calculating interest; most banks use a 360-day year. 5. Frequency of interest payments. If the note is on an interest-only basis, it will indicate how frequently interest must be paid. Interest is typically calculated on a daily basis but paid monthly. 27-18 Chapter 27 Providing and Obtaining Credit 6. Maturity. Long-term loans always have specific maturity dates. A shortterm loan may or may not have a specified maturity. For example, a loan may mature in 30 days, 90 days, 6 months, or 1 year, or it may call for “payment on demand,” in which case the loan can remain outstanding as long as the borrower wants to continue using the funds and the bank agrees. Banks virtually never call demand notes unless the borrower’s creditworthiness deteriorates, so some “short-term loans” remain outstanding for years, with the interest rate floating with rates in the economy. 7. Discount interest. Most loans call for interest to be paid after it has been earned, but discount loans require that interest be paid in advance. If the loan is on a discount basis, the borrower actually receives less than the face amount of the loan, and this increases the loan’s effective cost. We discuss discount loans in a later section. 8. Add-on basis installment loans. Auto loans and other types of consumer installment loans are generally set up on an “add-on basis,” which means that interest over the life of the loan is calculated and then added to the face amount of the loan. Thus, the borrower signs a note for the funds received plus the interest. The add-on feature also raises the effective cost of a loan, as we demonstrate in a later section. 9. Other cost elements. As noted above, some loans require compensating balances, and revolving credit agreements often require commitment fees. Both of these conditions will be spelled out in the loan agreement, and both raise the effective cost of a loan above its stated nominal rate. 10. Key-person insurance. Often the success of a small company is linked to its owner or to a few important managers. It’s a sad fact, but many small companies fail when one of these key individuals dies. Therefore, banks often require small companies to take out key-person insurance on their most important managers as part of the loan agreement. Usually the loan becomes due and payable should there be an untimely demise, with the insurance benefits being used to repay the loan. This makes the best of a bad situation— the bank gets its money, and the company reduces its debt burden without having to use any of its operating cash. Regular, or Simple, Interest In this and the following sections, we explain how to calculate the effective cost of different bank loans. For illustrative purposes, we assume a loan of $10,000 at a nominal interest rate of 12 percent, with a 365-day year. For short-term business loans, the most common procedure is called regular, or simple, interest, based on an interest-only loan. We begin by dividing the nominal interest rate, 12 percent in this case, by 365 (or 360 in some cases) to get the rate per day: Interest rate per day Nominal rate Days in year 0.12/365 (27-4) 0.00032876712. This rate is then multiplied by the number of days during the specific payment period, and then by the amount of the loan. For example, if the loan is interest-only, with monthly payments, then the interest payment for January would be $101.92: Interest charge for period (Days in period)(Rate per day)(Amount of loan) (31 days)(0.00032876712)($10,000) $101.92. (27-5) The Cost of Bank Loans 27-19 If interest were payable quarterly, and if there were 91 days in the particular quarter, then the interest payment would be $299.18. The annual interest would be 365 0.00032876712 $10,000 $1,200.00. Note that if the bank had based the interest calculation on a 360-day year, as most banks do, the interest charges would have been slightly higher, and the annual charge would have been $1,216.67. Obviously, banks use a 360-day year to boost their...
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