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BANK 404 CREDIT ANALYSIS AND LENDING

BANK 404 CREDIT ANALYSIS AND LENDING. WEEK 11 MEASURING EFFECTIVE INTEREST RATES FOR MICROLOANS Katherine Stearns (1991). INTEREST IS THE COST OF MONEY. INTEREST IS WHAT A BORROWER PAYS IN ORDER TO RENT MONEY FOR A CERTAIN PERIOD OF TIME

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BANK 404 CREDIT ANALYSIS AND LENDING

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  1. BANK 404CREDIT ANALYSIS AND LENDING WEEK 11 MEASURING EFFECTIVE INTEREST RATES FOR MICROLOANS Katherine Stearns (1991)

  2. INTEREST IS THE COST OF MONEY • INTEREST IS WHAT A BORROWER PAYS IN ORDER TO RENT MONEY FOR A CERTAIN PERIOD OF TIME • FOR MICRO AND SMALL BUSINESS CREDIT INSTITUTIONS, INTEREST INCOME DETERMINES WHETHER THE INSTITUTION IS DEPENDENT ON DONOR FUNDS OR ABLE TO MAINTAIN ITSELF WITH ITS OWN EARNED INCOME

  3. COST OF BORROWING (The Borrower’s Perspective) FINANCIAL COSTS (The Interest and Fees) TOTAL BORROWING = + COST TRANSACTIONS COST ( Bus fares, cost of obtaining documents, cost of time, missed investment opportunities due to delays in loan disbursement)

  4. COST OF LENDING(Lender’s Perspective) COST OF FUNDS (Interest paid on deposits and loans from other banks) + TOTAL LENDING COST =LOAN LOSS RESERVE (Default cost) + OPERATING COST (Salaries of staff, rent, other operating expenses)

  5. CASH FLOW OF LENDING TRANSACTION FINANCIAL COST INCOME (Interest, fees) BORROWERS LENDER Cost of Funds Loan loss reserve Operational cost Transaction Cost

  6. INTEREST RATES • NOMINAL RATES OF INTEREST Nominal rates of interest on a loan are the rates the lender states the borrower will pay • EFFECTIVE RATES OF INTEREST Effective interest rate is the actual rate that borrowers pay for a loan. Effective interest rates include all direct financial costs, such as, interest, fees and differences in interest payments due to the calculation method (eg. flat rate vs. declining balance) • REAL RATES OF INTEREST The real rate of interest is the rate of interest adjusted to allow for inflation, and is the interest rate minus the rate of inflation.

  7. INTEREST CALCULATIONS • SIMPLE INTEREST If the principal and interest are paid back in one payment, the interest calculation is referred to as simple interest. (e.g. $1000 to be repaid in 2 years at 5% annual interest. The principal $1000 and interest $100 ($1000 x .05 x 2 years) is paid end of the 2 years. • INSTALLMENT OR AMORTIZED LOANS Amortized loans are paid in equal, periodic payments (such as weekly, monthly or quarterly) payments of principal and interest over the life of the loan.

  8. CALCULATING AMORTIZATION SCHEDULES AMORTIZATION SCHEDULES CAN BE CALCULATED ON DECLINING BALANCE OR ORIGINAL LOAN AMOUNT • DECLINING BALANCE The amount of interest that the borrower pays during each payment period equals the nominal interest rate times the outstanding balance of the loan. • ORIGINAL LOAN AMOUNT (FLAT INTEREST) Flat interest is the amount of the interest that the borrower pays during each payment period equals the nominal interest rate times the original loan amount, no matter what the outstanding balance of the loan is during the period.

  9. AMORTIZATION SCHEDULE EXAMPLE 1: DECLINING BALANCE Amortization schedule of a 3 month, $100 loan with a nominal interest rate of 2% per month. Interest Principal Total Month Payment Payments Payments Balance $100.00 1(100 x 0.02) = $2.00 + $32.68 = $34.68 67.32 2(67.32x0.02) = 1.35 + 33.33 = 34.68 33.99 3(33.99x0.02) = .68 + 33.99 = 34.67 0.00 Total $ 4.03 + $100.00 = $104.03

  10. AMORTIZATION SCHEDULE EXAMPLE 2: ORIGINAL LOAN AMOUNT (FLAT INTEREST) Amortization schedule of a 3 month, $100 loan with a nominal interest rate of 2% per month. Interest Principal Total Month Payment Payments Payment Balance $100.00 1(100x 0.02) = $2.00 + $33.33 =$35.33 66.67 2(100x 0.02) = 2.00 + $33.33 = 35.33 33.34 3(100 x 0.02) = 2.00 + $33.34 = 35.34 0.00 Total $ 6.00 + $100.00 = $106.00

  11. EFFECTIVE RATES OF INTEREST • EFFECTIVE RATES OF INTEREST BRING ALL OF THE DIRECT FINANCIAL COSTS OF A LOAN TOGETHER IN ONE INTEREST RATE. (interest+fees+the calculation method+ other loan requirements) • EFFECTIVE INTEREST RATE IS THE SAME AS THE NOMINAL INTEREST RATE IF THERE IS NO ADDITIONAL FINANCIAL COST SUCH AS FEES, AND IF THE INTEREST IS CALCULATED ON A DECLINING BALANCE.

  12. CALCULATION METHODS THAT INCREASE THE FINANCIAL COST FOR BORROWERS • IF THE INTEREST IS CALCULATED ON THE ORIGINAL LOAN AMOUNT INSTEAD OF THE OUTSTANDING BALANCE. • IF THE INTEREST IS DEDUCTED FROM THE ORIGINAL LOAN AMOUNT BEFORE THE LOAN IS DISBURSED • A COMMISSION OR FEE. • A REQUIREMENT THAT THE BORROWER MAINTAIN A MINIMUM AMOUNT, A COMPENSATING BALANCE, IN A SAVINGS ACCOUNT IN ORDER TO RECEIVE A LOAN.

  13. CALCULATING EFFECTIVE INTERESTRATES FOR SIMPLE INTEREST LOANS FOR LOANS WITH ONLY ONE PAYMENT AT THE END (i.e. SIMPLE INTEREST LOANS) CALCULATING THE EFFECTIVE INTEREST RATE IS EASY. THE EFFECTIVE INTEREST RATE IS THE AMOUNT THE BORROWER PAYS IN INTEREST, FEES, AND COMMISSIONS, DIVIDED BY THE AMOUNT THE BORROWER RECEIVES. Amount paid in interest, fees, and commissions Effective Interest Rate = Principal amount received by borrower

  14. CALCULATING THE EFFECTIVE INTEREST RATE FOR AMORTIZED LOANS IT IS EASIER TO USE A FINANCIAL CALCULATOR TO CALCULATE THE EFFECTIVE INTEREST RATE FOR AMORTIZED LOANS EXAMPLE 1 (Loan With a Commission) Calculate the effective interest rate of a $100, 3 month loan with a nominal interest rate of 2 % per month and a commission of 5% paid upon loan disbursal: a) PV = 100, N = 3, i = 2 b) Solve for payment: PMT = 34.68 c) Enter monthly payment, PMT = 34.68 , and the amount the borrower effectively received PV= 95, and the number of payments, N = 3. d) Solve for effective interest rate: i = 4.7% (per month)

  15. CALCULATING THE EFFECTIVE INTEREST RATE FOR AMORTIZED LOANS EXAMPLE 2 (With Flat Interest Rate) The original loan amount is $100, the loan period is 3 months with monthly payments, and the nominal interest rate is 2%. a) principal : 100/3 = 33.33 per month b) interest: (100x 0.02) = 2.00 per month total monthly payment = 35.33 c) enter PMT=35.33 , the amount the borrower received, PV = 100, and the number of payment periods N =3 d) solve for effective interest rate i = 2.97 % per month.

  16. CALCULATING THE EFFECTIVE INTEREST RATE FOR AMORTIZED LOANS EXAMPLE 3 Interest Deducted Up Front From the Original Loan Amount The original loan amount is $100, the loan period is 3 months with monthly payments, and the nominal interest rate is 2%. PV = 100 N = 3 i = 2%

  17. Find the amount to be paid in interest: a) First, find the monthly payment, PMT. PMT = $34.68 b) The total paid for 3 months will be 34.68 x3= $ 104.04. c) Interest paid will be: $104.04 - $100 = $ 4.04 d)Solve for the effective interest rate: enter PMT = 33.33 (100/3 =33.33 ) PV = 95.96 (100 - 4.04 = 95.96) N = 3 d) solve for the interest rate: i = 2.09 %

  18. REAL RATES OF INTEREST • REAL RATES OF INTEREST ARE RATES THAT HAVE BEEN ADJUSTED TO COMPENSATE FOR THE EFFECTS OF INFLATION, AND IS THE INTEREST RATE MINUS THE RATE OF INFLATION. • SUBTRACTING THE INFLATION RATE FROM THE INTEREST RATE PRODUCES AN APPROXIMATION OF THE REAL INTEREST RATE. AS INFLATION INCREASES, HOWEVER, THIS APPROXIMATION BECOMES LESS ACCURATE AND THE FOLLOWING FORMULA SHOULD BE USED: Real (1 + nominal interest rate ) interest rate = _ 1 (1 + inflation rate)

  19. THE EFFECTS OF INFLATION ON THE VALUE OF A PORTFOLIO THE EFFECTS OF INFLATION ON THE VALUE OF A PORTFOLIO CAN BE CALCULATED WITH THE FOLLOWING FORMULA: VPi VPf = (1+i) VPf = Value of the portfolio at the end of the period VPi = Value of the portfolio at the beginning of the period i = The rate of inflation of the period

  20. ESTABLISHING INTEREST RATES FOR SELF-SUFFICIENCY • IN ORDER TO BE SELF-SUFFICIENT, FINANCIAL INSTITUTIONS NEED TO DESIGN AN INTEREST RATE AND FEE STRUCTURE THAT GENERATE ENOUGH INCOME TO COVER THEIR COSTS. • INCOME = INTEREST EARNINGS ON PORTFOLIO FUNDS + FEES OR COMMISSIONS • COSTS = THE COST OF FUNDS + LOAN LOSS RESERVE + OPERATIONAL COSTS.

  21. ESTABLISHING INTEREST RATES FOR SELF-SUFFICIENCY EXAMPLE 1: ( Determining The Needed Rate ofReturn) Estimated rate of inflation: 18 % Own funds in portfolio: $500,000 Borrowed funds in portfolio: $300,000 Total portfolio: $800,000 Effective interest rate on borrowed portion of portfolio: 15 % Estimated Annual loan loss: 3 % Operating Cost as a % of total portfolio 22 % CALCULATION a) Total cost of funds is: (.63)x(.18) + (.37)x(.15) = .1689 17 % b) Estimated loan loss: 3 % c) Operating margin: 22 % Total: 42 %

  22. EFFICIENCY IS ESSENTIAL FOR MICROENTERPRISE FINANCIAL INSTITUTIONS • CREDIT INSTITUTIONS COSTS (ESPECIALLY OPERATING COSTS AND THOSE RELATED TO MAINTAINING A LOAN LOSS RESERVE) DEPEND ON THEIR EFFICIENCY. BORROWERS SHOULD NOT HAVE TO PAY HIGH INTEREST RATES TO COVER A PROGRAM’S INEFFICIENCIES. • THE OPERATING COST OF AN EFFICIENT MICROENTERPRISE FINANCE INSTITUTION IS APPROXIMATELY 15% OF THE TOTAL LOAN PORTFOLIO.

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