To be honest I struggled with how to title and explain parts of this course when explaining banking
words.
I wanted to call them banking terms but the word term has a special technical definition in lending.
In fact I'm going to show you how you may have a single loan with multiple types of terms in lending.
The word term refers to a period of time commercial real estate loans often have three types of loan
terms a repricing term a balloon term and an amateur ization term so in lending the word term refers
to a period of time business loans often have three types of loan terms are repricing term a balloon
term and an average ization term.
Let's look at each the repricing term as how frequently your loan rate changes for floating rate loans.
The interest rate changes whenever the index rate changes.
When I worked at banks we went into a mad scramble whenever the Fed changed the fed funds rate because
it causes the prime rate to change.
We had to update our systems that day and make sure customers were charged the correct floating rate
at the other end of the spectrum or fixed rate loans.
They don't have a repricing term variable rate loans lie somewhere between floating rate loans whose
rate can change any day and fixed rate loans that never change the rate on a variable rate loan can
change once a month once a quarter once a year or every few years based on the loan agreement.
The balloon term is when the remaining principal is due.
You may understand this better if I explain it with an example.
Let's assume you have a loan with a 10 year balloon term.
You would make periodic PMI payments for 10 years.
The monthly principal portions of your loan payments are reducing your principal balance over time.
At the end of the tenth year of your loan the whole amount of any unpaid principal is due.
It might be a large amount.
You may be wondering why the loan wouldn't be set to gradually pay down to zero by the end of the tenth
year.
That's because many business loans have amortization terms that are longer than their balloon terms.
I'll explain that next.
The Amitai ization term is the length of time it would take to pay the loan to zero at your loan payment.
So let's go back to our 10 year balloon loan term.
If it has a 25 year Amman ization term it would take twenty five years to pay the principal down to
zero at the 10 year point when the balloon term ends.
You still have a good chunk of unpaid principal balance.
I'll explain this with the picture I'm going through this detail on loan terms because commercial real
estate loans often have different repricing terms.
Balloon terms and amortization terms the terms in this graph were one of the most common if not the
most common structure of commercial real estate terms at banks I worked at.
That structure is a set of two five year repricing terms with a 10 year balloon term and a twenty five
year amortization term.
You may hear lenders talk about a twenty five year ARM which means a twenty five year amortization term.
The solid line in the graph is the principal balance of the loan.
The dotted line is what the principal balance would have been if the balloon payment wasn't due at the
end of the tenth year looked down at the bottom left quadrant of the graph.
The bottom two sets of arrows show the two five year repricing terms.
All the principal is due in the tenth year which is why the principal balance which the solid line goes
from over eight hundred thousand dollars to zero in year 10.
Notice that the balloon term is 40 percent of the amortization term.
If you calculate it as 10 years divided by twenty five years however the principal balance is paid down
less than 20 percent during those 10 years.
The principal reduction of advertising loans starts slowly and then increases during the loan.
You can see this in the arc of the solid line leading to the dotted line.
The amortization term the payment amount is set so that if you would have kept making the same total
payment dollar amount and rates never changed and you didn't have a balloon payment your last payment
at year twenty five would pay the principal balance to zero.
Leave it to bankers to make a loan that's this complicated.
Why do bankers do this.
The answer is to give business customers what they want.
As a recovering banker let me try to explain for my former co-workers the longer the repricing term
the higher the interest rate market rates like Treasury rates usually increase with longer terms due
to the higher risk and uncertainty there's the risk that inflation will be higher in the future rates
will increase for some other reason.
The sources of funding for a bank increase with longer terms and the price they charge to borrowers
increases with longer terms so borrowers often choose 5 year or even 3 year repricing terms to reduce
their interest rate and interest expense.
That explains why repricing terms are a few years.
But why is the balloon term shorter than the amortization term.
The shorter the balloon term the lower the interest rate.
The cash comes back sooner to the bank which reduces risk and discount rates so banks can pass those
savings on to the borrower.
Another way banks profitability improves with balloon terms is because larger loans are cheaper for
banks to service efficiency increases with loan size.
A bank servicing lots of small loans near the end of their amortization periods would have to pass along
the cost of that inefficiency to borrowers be a higher interest rates.
Okay then why is the Ammad ization period so long.
Why is it longer than the balloon term.
The longer the amortization term the lower the total monthly payment each month the monthly payment
for a million dollar loan at 7 percent interest with a 25 year amortization is seven thousand sixty
seven dollars short in that amortization term to ten years and the payment goes up to eleven thousand
six hundred eleven dollars an increase of four thousand five hundred and forty four dollars or sixty
four percent.
Businesses usually take out loans because cash is tight or they need the cash for other purposes.
These businesses want longer amortization periods to reduce the monthly cash burden of the loan payments.
Having an advertiser Asian term that's longer than your balloon term does create an event for which
you need to prepare the big balloon payment at the end of your 10 businesses generally do one of two
things.
If they have lots of cash at the end of the balloon term they may pay off the loan and be done.
Many businesses take out a new loan at the balloon term.
This loan may be larger than their original loan because the value of the collateral the real estate
has gone up and they want to tap into that cash before we go into the next section on different types
of loans.
I want to cover why you should match the term of your loans to cash flows.
If you borrow from a short term line of credit a credit card for equipment or real estate you will need
to pay back those loans long before the acid has had time to earn cash for you to pay back the loan.
This would cause a cash crunch also called a liquidity crisis.
Use short term financing for short term needs and longer term financing for equipment and real estate
however even current assets may give rise to long term financing needs.
One example is permanent working capital.
Working capital is the difference between your current assets and your current liabilities.
Permanent working capital increases when receivables rise and won't go back down and until production
goes down which may be very very far in the future.
If ever your receivables are constantly some portion of your sales when your sales increase your receivables
increase and they won't decrease until your sales decrease.
This is part of the funding needed for growth that companies don't anticipate increases in permanent
working capital need funded with long term debt or equity.