Introduction to Loans

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Introduction to Loans
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Why Borrow Money?

• You dont have the cash on hand
• Dont want to wait until you save enough
• Large ticket items and/or expansion
• House, car, land, farm, etc.
• Dont want to use your money
• Help improve your cash flow
• Tax breaks on interest payments
• Emergencies
• Convenience

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Loan Basics

• Down Payment
• Cash payment needed up-front
• Principal
• Amount of money borrowed
• Annual Percentage Rate (APR)
• Actual interest cost of the loan
• Term
• Life of the loan (Years until paid off)
• Points
• 1 point 1 percent of the loan amount
• Up-front interest charge

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Main Considerations

• Down Payment
• Can you afford it
• Interest Rate
• Fixed or variable
• Amount Borrowed
• How much can you repay?
• Payments
• Amount and timing
• Prepayment Penalty
• Is there a fee for prepayment? (Rule of 78s )

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General Borrowing Limits

• Debt Payment/Income Ratio
• Annual Debt Payments divided by Gross Income
• Rules of Thumb
• PITI/Inc lt 28 for housing payments
• Includes mortgage payment, taxes, insurance
• DP/Inc lt 38 (some say 40) for total debt
  payments
• Includes credit cards, car loans, etc.
• Repayment ability, solvency, risk attitude,
  credit history determine the amount you can borrow

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Ag Borrowing Limits

• Depends on the lenders underwriting
• Certain limits/ranges for various ratios
• Typically examine your
• Liquidity solvency
• Profitability repayment ability
• Collateral Loan/Value ratio
• Financial efficiency
• Credit history

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Main Types of Loan Payments

• Equal Payment (Amortized)
• Payment remains constant over life of loan
• Use PMT function to determine payment
• Most loans are Equal Payment
• Equal Principal
• Payment Principal/Term Interest
• Total payment decreases over time
• Interest charges decrease as you pay off
  principal
• Others
• Balloon payment, unscheduled, etc.

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Car Loans

• Dealer cost is about 85 of sticker price
• 20,000 sticker price 17,000 dealer cost
• Trade-in Values
• What is your vehicle worth (www.kbb.com)
• Extended warranties arent worth it
• Include after-market items in loan?
• Insurance maintenance costs
• Can you make your insurance and car payments, and
  still have enough to maintain the car (gas, oil,
  etc.)

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Car Loans

• Simple Interest Loans
• Rather than add-on or discount loans
• Look at Credit Unions for lowest rates
• Beware dealer financing - read the fine print!
• Make as big a down payment as possible
• Lower interest rate, smaller payments
• Maintain your emergency fund though!
• Prepayment Penalties
• Can you make double payments?
• Lease vs buy?

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Car Loan Payments

• Dont fall into low monthly payment trap
• 15,000 loan
• 3-year, 9 477/month Total Int. 2,172
• 5-year, 9 311/month Total Int. 3,683
• Stretch payments over long time period, but
  prepay if you can!
• Lowers monthly payment required
• Good during hard times
• Prepay (without penalty)
• Lowers total interest cost
• Pays off loan faster

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Operating Loans

• Used for purchase of operating inputs
• Seed, feed, fertilizer, feeder calves, etc.
• Usually a 1-year (or less) loan
• Borrow a set amount
• Purchase your inputs
• When product is sold, repay principal interest

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Operating Line of Credit

• For operating expenses
• Acts like a credit card
• You are qualified for a certain limit
• You borrow as you need funds, up to the limit
• You pay back as you can (usually w/i 1 year)
• May have to make interest-only payments
• Try to repay all principal when you sell your
  product

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Equipment Loans

• Terms vary new vs used
• Typically
• Term of 1-7 years (3-5 years is most common)
• Fixed interest rate
• Payments set up to match your cash flow
• Monthly, semi-annually, etc.
• Equipment is used as collateral
• If you dont pay, lender repos your livestock

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Livestock Loans

• Feeder Livestock
• Operating loan (interest only loans)
• To be repaid in full when livestock are sold
• May be variable interest rate (tied to index)
• Breeding Livestock
• 1-5 year loans
• Scheduled payments
• Livestock are used as collateral

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Mortgages

• A mortgage is a loan for real estate
• Houses, land, farms, buildings, businesses, etc.
• Property is collateral (security)
• If you default, the lender takes ownership of the
  property
• Foreclosure, repossession
• Typically over a longer time period
• 10-30 years

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Types of Mortgages

• Fixed Rate Mortgage
• Interest rate is fixed (constant) for the term of
  the loan
• Usually 10-30 year terms
• Adjustable Rate Mortgages (ARMS)
• a.k.a. variable rate mortgages
• Interest rate varies over time
• Typically lower beginning interest rate than
  fixed rate mortgages

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Fixed Rate Mortgages

• Provides less risk to borrower than ARMs
• Avoids fluctuations in interest rate
• Good if rates increase, bad if they decrease!
• Avoids fluctuations in monthly payments
• Safer for people in weak financial condition
• Initial interest rates are higher than ARMs
• More risk for lender (Higher risk, higher return
  ...)
• Dont forget about Points
• Impacts the interest you pay up-front
• Lower rates for 10-year vs 30-year loans

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15-year vs 30-year Mortgage

• 15-year Mortgage
• 100,000, 7
• 898.83/month
• 61,789 total interest

• 30-year Mortgage
• 100,000, 7
• 665.30/month
• 139,508 total interest
• 30-yr usually have higher interest rates

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Adjustable Rate Mortgages (ARMs)

• Interest rate tied to some index
• Index plus margin (LIBOR 1.75)
• More risk for borrower
• Monthly payments will vary over term of loan
• Increasing interest rates means higher payments
• Can your cash flow handle the risk?
• Initial interest rate is typically lower
• But can increase over time!

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Types of ARMs

• 1-year ARM
• Interest rate can change every year
• 3-year ARM
• Interest rate can change every 3 years
• 5/1-year Arm
• Initial interest rate is fixed for 5 years
• After 5 years, interest rate can change yearly

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ARM Terminology

• Points
• Up-front interest cost
• Cap
• Limit on interest rate increases
• 2/5 cap max. 2 increase/yr 5 increase over
  term
• Index
• Basis for variable rates
• 11th District Cost of Funds, LIBOR, 1-yr Treasury
  index
• Margin
• Amount added to index to determine variable rate
• Rate Index Margin

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Fixed Rate vs ARM

• Depends on
• Interest rates
• Points
• How long you plan on carrying the mortgage
• 5-7 year rule (Low payments vs Points)
• lt 7 years - go with ARM gt 7 years - go with
  fixed
• Your cash flow
• Your ability to handle shocks (like higher
  payments)
• Amount of down payment required
• What you expect interest rates to do
• If rates are low, Fixed are typically better
• If rates are high (10), ARMs may be better

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Fixed Rate vs ARM Example

• ARM
• 100,000, 5, 1-yr, 2/6 cap
• Int/yr Cum. Int
• 4,966 4,966
• 6,858 11,824
• 8,715 20,539
• 10,533 31,072
• 10,405 41,477

• Fixed Rate
• 100,000, 7, 15 years
• Year Int/yr Cum. Int
• 1 6,968 6,968
• 2 6,894 13,862
• 3 6,816 20,678
• 4 6,731 27,409
• 5 6,641 30,450

ARM figures assume worst case scenario
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Main Considerations

• Down Payment
• Can you afford it
• Interest Rate Term (years)
• Fixed or variable
• Rapid payoff/higher payments vs slower
  payoff/lower payments
• Amount Borrowed
• How much can you repay?
• Payments
• Amount and timing
• Prepayment Penalty
• Is there a fee for prepayment? (Rule of 78s )

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Als Suggestions

• Know your cash flow BEFORE getting a loan
• When in doubt, choose the longer term
• Prepay as you go if you have the cash flow
• Match your loan payments to your cash flow
• Work WITH your lender
• Lender is your business partner
• Keep your Debt Payment ratio lt 55
• This includes mortgage, consumer ag debt

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Borrowing Suggestions

• Try to have all of your loans with the same bank
• Avoid split lines of credit
• Be prepared to meet your lender
• 2-3 years of financial information
• Balance Sheet, Income Statement
• Cash Flow Statement
• Breakevens, business plan