I needed to find some words used in lending before you will be able to understand details about the
types of business loans.
We'll start with principal and interest.
A simple definition for principal is that it's the amount of the loan.
Sometimes people call it the balance or outstanding balance of the loan.
This definition works well for real estate loan where you get a large amount of principal at the beginning
of a loan and you make periodic payments to reduce that principal over the life of the loan.
Lines of credit have a commitment amount that's the maximum amount that can be borrowed at any time.
Let's say you have a line of credit with a commitment amount of one hundred thousand dollars.
You don't take any advances on this line for the first month in month 2 you transfer ten thousand dollars
from the line to your checking account.
This is called an advance or a draw on the line at this point.
The commitment amount is still and will always be one hundred thousand dollars.
The principal balance is ten thousand dollars.
The difference between these two of ninety thousand dollars is your available balance.
The principal balance is listed on the balance sheet.
The commitment amount and available balance would be disclosed in the notes to the financials.
I talk more about disclosures later in this course though.
OK now let's talk about cash outflows and expenses.
Interest is a part of the cost of the loan.
The other parts are fees and penalties and they'll be discussed later.
The interest payment amount of a loan is calculated as the interest rate times the principle of a loan.
Loan payments may be interest only principle only or a combination of both construction loans are an
example of interest only loans.
The borrower only pays interest and not principal during construction.
Once construction is completed it's converted to or paid off by a regular commercial real estate term
loan.
An example of both interest only payments and principal only payments are lines of credit.
Let's continue with our line example from the previous slide in month 3.
You would own interest only payment for the interest accrued during month 2.
This is an interest only payment if you decided to pay down the line to zero in month 3.
This would be a principal only payment payments for term loans on equipment or real estate or a combination
of interest and principal.
Bankers often call these types of payments PMI payments for principal and interest payments the rate
on a floating or variable rate loan is calculated as the index rate plus or minus a spread.
Let's look in more detail at each of those two components the index is usually a rate that's widely
used in financial markets.
Examples include the prime rate Treasury rates or borrowing rates from a Federal Home Loan make or FHA
I'll be for short FHA LP as are special banks whose only customers are banks credit unions or insurance
companies.
The FHA Shelby's provide funding for those other financial institutions.
The primary may be the bank's primary or the Wall Street prime rate which is published in The Wall Street
Journal the spread is the amount that's added to the index rate to arrive at the total interest rate
you pay on your loan.
For example if the prime rate is four point seventy five percent and you are charged a 2 percent spread
then you pay a total interest rate of six point seventy five percent.
The riskier you are as a borrower the higher the spread that's added to the index rate.
Now let's talk about a little piece of the fine print and loan agreements that increases the rate borrowers
pay.
There are different ways that days can be counted or allocated when calculating how much interest you
on each payment for the explanations and examples in the next couple slides will assume monthly payments.
The method for calculating the days is called the day count basis or the day count method.
Actual actual is calculated as the actual number of days in the month divided by the actual days in
the year actual 360 is calculated as the actual number of days in the month divided by three hundred
and sixty.
The actual 360 basis is common in business loans.
The interest paid on an actual 360 basis is higher than an actual actual basis.
The denominator of 360 in an actual 360 is higher than the 365 or 366 used in actual actual hold tight.
If I've lost you I'm going to show you an example here.
I know CPA or show me the numbers types.
So here's an example.
Let's assume you have a loan with a million dollar principal balance bearing 7 percent interest.
Let's calculate your January interest payment using the actual actual an actual 360 methods using actual
actual you would multiply the million dollars times point 0 7 for the 7 percent interest.
Times the 31 days in January divided by the three hundred and sixty five days in a normal year.
Your January interest payment is roughly five thousand nine hundred forty five dollars.
Now using actual 360 you multiply the million dollars times Point zero seven times the 31 days in January
divided by 360 your January interest payment is now roughly six thousand twenty eight dollars.
If you summed up all the actual actual payments for the year total interest costs are seventy thousand
dollars which is what you would expect if you multiplied a million dollars times 7 percent interest.
However you would pay a total of seventy thousand nine hundred seventy two dollars using an actual 360
basis.
If you divided that seventy thousand nine hundred and seventy two dollars by the million dollars principal
it would equal around seven point 1 0 percent.
In other words the lender has increased their interest rate by point 1 0 percent by using the actual
360 day count basis.
I'm pointing this out so you can make apples to apples comparisons of loan rates from different lenders.
They may both say they are charging you 7 percent but if they use two different discount bases then
you will pay less with one of those lenders.
It's a little thing to pay attention to.