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

Short-Term Loans to Business Firms (continued)

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

Short-Term Loans to Business Firms (continued)

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 involved
2. The project may be delayed by weather or shortage of materials
3. Laws and regulations in the region where the project lies may change
4. 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 borrowers profits or cash flow
2. Business assets pledged as collateral behind the loan
3. A strong balance sheet with ample amounts of marketable assets and net
worth
4. 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 Borrowers Financial Statements

Analyzing Business Loan Applications

(continued)
Analysis of a Business Borrowers Financial Statements

Financial Ratio Analysis of a Customers

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 expenses
2. Operating efficiency in using resources to generate sales
3. Marketability of product line
4. Coverage that earnings provide over financing cost
5. Liquidity position, indicating the availability of ready cash
6. Track record of profitability
7. 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 Customers

Financial Statements (continued)
The Business Customers Control over Expenses

A barometer of the quality of a firms 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 firms 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 Customers

Financial Statements (continued)
Operating Efficiency: Measure of a Business Firms Performance Effectiveness
It is also useful to look at a business customers 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 Customers

Financial Statements (continued)
Operating Efficiency: Measure of a Business Firms Performance Effectiveness

Marketability of the Customers 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 Customers

Financial Statements (continued)
Marketability of the Customers Product or Service
A closely related and somewhat more refined ratio is the net profit margin
(NPM)

Financial Ratio Analysis of a Customers

Financial Statements (continued)
Coverage Ratios: Measuring the Adequacy of Earnings
Coverage refers to the protection afforded creditors based on the amount of a
business customers earnings
The best-known coverage ratios include

Financial Ratio Analysis of a Customers

Financial Statements (continued)
Liquidity Indicators for Business Customers
The borrowers 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 Customers

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 Customers

Financial Statements (continued)
The Financial Leverage Factor as a Barometer of a Business Firms 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 businesss credit standing
and use of financial leverage include

Comparing a Business Customers Performance to

the Performance of Its Industry
It is standard practice to compare each business customers performance to the
performance of the customers entire industry
Dun & Bradstreet Industry Norms and Key Business Ratios
RMA Annual Statement Studies

Comparing a Business Customers 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 firms 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 firms assets and
earnings at a future date
Loan officer must ask the customer about pending or potential claims against the firm

Comparing a Business Customers 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 Customers 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)

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

Pricing Business Loans (continued)

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

Pricing Business Loans (continued)

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

Pricing Business Loans (continued)

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

Pricing Business Loans (continued)

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

Pricing Business Loans (continued)

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 customers 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 Boards 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 borrowers ability to pay
Consumer lenders nearly always check with one or more credit bureaus
concerning the customers 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 officers
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 borrowers payment history
2. The amount of money owed
3. The length of a prospective borrowers 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 borrowers income
Appraisals are critical to the loan decision and must meet industry standards and
government regulations

Real Estate Loans (continued)

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 lenders other financial services

Real Estate Loans (continued)

Factors in Evaluating Applications for Real Estate Loans
Other aspects of each credit application that require assessment:
Amount and stability of the borrowers income
The borrowers available savings and where the borrower will obtain the
required down payment
The borrowers 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

Real Estate Loans (continued)

Home Equity Lending
Homeowners can borrow the equity in their homes
Equity is defined as the difference between a homes estimated market value
and the amount of the mortgage loans against it
Two main types of home equity loans:
1. Traditional Home Equity Loan
2. Lines of Credit Against a Homes Borrowing Base

Real Estate Loans (continued)

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

Real Estate Loans (continued)

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

Real Estate Loans (continued)

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 loans 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 debtors 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

Pricing Consumer and Real Estate Loans: Determining

the Rate of Interest and Other Loan Terms (continued)
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

Pricing Consumer and Real Estate Loans: Determining the

Rate of Interest and Other Loan Terms (continued)
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

Pricing Consumer and Real Estate Loans: Determining

the Rate of Interest and Other Loan Terms (continued)
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 customers 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

Pricing Consumer and Real Estate Loans: Determining the Rate of

Interest and Other Loan Terms (continued)
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

Pricing Consumer and Real Estate Loans: Determining

the Rate of Interest and Other Loan Terms (continued)
Interest Rates on Home Mortgage Loans
Since the 1930s, most loans to finance the purchase of new homes were fixedrate 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

Pricing Consumer and Real Estate Loans: Determining the Rate of

Interest and Other Loan Terms (continued)
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

Pricing Consumer and Real Estate Loans: Determining

the Rate of Interest and Other Loan Terms (continued)
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