# Agriculture & Business Management Notes...

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3 or unforeseen problems that will interfere with making loan payments. Finally, maintain a high level of integrity. If a lender is expected to be honest and above board at all times, then the same attribute will be expected of you, the borrower. Inaccurate information and failure to honor commitments will jeopardize the borrower-lender relationship initially and could last a lifetime. Calculating Interest Charges on Loans Lenders use three major methods to calculate interest charges: 1. The add-on method 2. The discount method 3. The remaining balance method The first two methods are not commonly used by major agricultural lenders, but are used by finance companies that may make some agricultural loans. Add-on Method: Under the add-on method, the lender calculates the total interest charge by multiplying the entire loan amount by the contractual interest rate, and then multiply the total interest cost by the number (months, years) covered by the loan. The interest charge is added to the principal to determine the total amount to be repaid. This amount is then divided by the number of repayment periods to determine each payment. Example: Assume a \$3,000 loan to be repaid in two annual installments. The annual contractual interest rate is 6 percent. Then the total interest charge is: \$3,000 x.06 x 2 = \$ and the annual payments will be: (\$3, ) divided by 2 = \$1, Discount Method: The discount method calculates total interest the same way as the add-on method, with one exception. The interest is subtracted from the loan amount and the borrower receives the balance. Example: Using the same data as before (\$3,000 loan amount, 6 percent annual interest rate, over 2 years). The total interest charge is again \$ \$3,000 x.06 x 2 = \$ The borrower would receive \$2,640.00: \$3,000 - \$ = \$2, And would repay two installments of \$1, each: \$3,000 divided by 2 = \$1, Remaining Balance Method: When the remaining balance method is used, the interest charge is computed in each period by multiplying the contractual interest rate by the principal balance remaining at the beginning of the period (the unpaid balance). The major difference between this method and the previous two, beyond the complexity of the mathematical calculations, is that interest is not charged on principal that has been repaid. Long-Term Loan Repayment Methods Money borrowed for long-term capital investments usually is repaid in a series of annual, semi-annual or monthly payments. There are several different ways the amount of these payments can be calculated. For example, loans may be repaid in a series of 1) equal total payments per time period (amortization); 2) equal principal payments per time period; or 3) equal payments over a specified time period with a balloon payment due at the end to repay the balance. Equal total payment method: Each payment includes the accrued interest on the unpaid balance, plus some principal. The amount of the annual payment applied toward the principal will increase with each payment. 3

4 Example: Assume a \$10,000 loan at a 12 percent annual contractual rate to be repaid in eight annual payments. Under the equal total payment method, the annual payment for this loan is \$2, for each of the 8 years. This was determined by multiplying the amortization factor for 12 percent interest and 8 year payment period times the loan amount. The portion of each payment that is interest and the portion that is principal will vary with each payment. At the end of the first year, interest is charged on the full \$10,000 principal outstanding: Interest = \$10,000 x 0.12 = \$1,200 Thus, the principal payment is the difference: Principal payment = \$2, \$1,200 = \$ The remaining principal balance after the first payment is: Remaining principal balance = \$10,000 - \$813. = \$9,187. Interest in the second year is charged on the remaining balance: Interest = \$9,187 x 0.12 = \$1, Principal payment = \$2,013 - \$1,102 = \$ Remaining principal balance = \$9,187 - \$ = \$8, Equal principal payment method: The equal principal payment plan also provides for payment of accrued interest on the unpaid balance, plus an equal amount of the principal. The total payment will decline through time because, as the remaining principal balance declines, the amount of interest accrued declines. Example: Assume the same loan as above, (\$10,000, 12 percent interest, to be repaid in eight annual payments). First Year: Interest = \$10,000 x 0.12 = \$1,200 Principal Payment = \$10,000 8 = \$1,250 Total payment 1st year = \$1,250 + \$1,200 = \$2,450 Remaining Principal Bal. = \$10,000 - \$2,450 = \$8,750 In the second year: Interest = \$8,750 x 0.12 = \$1,050 Principal Payment = \$1,250 Total Payment = \$1,250 + \$1,050 = \$2,300 Remaining Principal Balance = \$8,750 - \$1,250 = \$7,500 These two payment plans are the most common methods financial institutions use to compute loan payments on long-term investments. Individual lenders will use both of these, but also may use a balloon system. The balloon payment method often is used to reduce the size of periodic payments, but also to shorten the total time period in which the loan is fully repaid. To accomplish this, a portion of the principal will not be amortized (paid off in a series of payments) but will be due in a lump sum at the end of the loan period. For many borrowers, this means the amount to be repaid in the lump sum must be refinanced, which may be difficult. Variable Interest Rates: Many lenders now use variable interest rates, which greatly 4

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