LoansAndAmortizationIntroductionToLoans

Businessesoftenneedtoborrowmoneytofinancebusinessinvestmentactivities.Herearesomeofthetypesofloansa
businessmighttakeout.BasicLoans
Acommercialloanisadebtbasedfundingarrangementthatabusinesscansetupwithafinancialinstitution.The
proceedsofcommercialloansmaybeusedtofundlargecapitalexpendituresand/oroperationsthatabusinessmay
otherwisebeunabletoafford.Thistypeofloanisusuallyshortterminnatureandisalmostalwaysbackedwithsome
sortofcollateral.Commercialloansusuallychargeflexibleratesofinterestthataretiedtothebankprimerateorelseto
theLondonInterbankOfferedRate(LIBOR).Manyborrowersmustfileregularfinancialstatements,usuallyatleast
annually.Lendersalsousuallyrequirepropermaintenanceoftheloancollateralproperty.
Duetoexpensiveupfrontcostsandregulationrelatedhurdles,smallerbusinessesdonottypicallyhavedirectaccessto
thedebtandequitymarketsforfinancingpurposes.Therefore,theymustrelyonfinancialinstitutionstomeettheir
financingneeds.
Atermloanisaloanfromabankforaspecificamountthathasaspecifiedrepaymentscheduleandafloatinginterest
rate.Termloansalmostalwaysmaturebetweenoneand10years.Businessesusetermloansformonthtomonth
operationsortopurchasefixedassetssuchasproductionequipment.
Anunsecuredloanisissuedandsupportedonlybytheborrower'screditworthiness,ratherthanbysomesortof
collateral.Generally,aborrowermusthaveahighcreditratingtoreceiveanunsecuredloan.Commercialpaperisan
exampleofanunsecuredloan.Asecuredloanisbackedbycollateral;ifitisnotrepaid,thelendercanseizethe
collateralandsellittorecoverthefundsitlent.
Anacquisitionloanhelpsacompanypurchaseaspecificassetthatisdeterminedbeforetheloanisgranted.
Acquisitionloansaresoughtwhenacompanywantstocompleteanacquisitionforanassetbutdoesnothaveenough
liquidcapitaltodoso.Thecompanymaybeabletogetmorefavorabletermsonanacquisitionloanbecausetheassets
beingpurchasedhaveatangiblevalue,asopposedtocapitalbeingusedtofunddailyoperationsorreleaseanew
productline.Theacquisitionloanistypicallyonlyavailabletobeusedforashortwindowoftimeandonlyforspecific
purposes.Oncerepaid,fundsavailablethroughanacquisitionloancannotbereborrowedaswitharevolvinglineof
creditatabank.
RevolvingCredit
Revolvingcreditisanotherwaybusinessescanborrowmoney,butthestructureisabitdifferentthananordinaryloan.
Alineofcreditestablishesamaximumloanbalancethatthebankwillpermittheborrowertomaintain.Theborrower
candrawdownonthelineofcreditatanytime,aslongasheorshedoesnotexceedthemaximumsetintheagreement.
Theadvantageofalineofcreditoveraregularloanisthatinterestisusuallychargedonlyonthepartofthelineof
creditthatisused,andtheborrowercandrawonthelineofcreditatanytime.Dependingontheagreementwiththe
financialinstitution,thelineofcreditmaybeclassifiedasademandloan,whichmeansthatanyoutstandingbalance
willhavetobepaidimmediatelyatthefinancialinstitution'srequest.
Revolvingcreditmayalsobecalledanevergreenloanorastandingloan.Creditcardsarealsoatypeofrevolving
credit.
MoreComplexLoans
Aselfliquidatingloanisatypeofshortorintermediatetermcreditthatisrepaidwithmoneygeneratedbytheassets
purchased.Therepaymentscheduleandmaturityofaselfliquidatingloanaredesignedtocoincidewiththetimingof
theassets'incomegeneration.Theseloansareintendedtofinancepurchasesthatwillquicklyandreliablygenerate
cash.
Abusinessmightuseaselfliquidatingloantopurchaseextrainventoryinanticipationoftheholidayshoppingseason.
Therevenuegeneratedfromsellingthatinventorywouldbeusedtorepaytheloan.
Selfliquidatingloansarenotalwaysagoodcreditchoice.Forexample,theydonotmakesenseforfixedassets,suchas
realestate,ordepreciableassets,suchasmachinery.

Anothertypeofloanrelatedtoabusiness'sassetsisanassetconversionloan,ashorttermloanthatistypicallyrepaid
byconvertinganasset,usuallyinventoryorreceivables,intocash.
Forexample,let'ssaytheTSJSportsConglomerateisshortoncashitneedstopayitsemployeesthismonth.One
optiontheymightexploreistryingtogetanassetconversionloantofillthatshorttermcashvoid.
Anothertypeofloanthatcanhelpabusinessmeetitsdaytodayneedsisacashflowloan.Reasonsforneedingacash
flowloancouldbeseasonaldemandchanges,businessexpansionorchangesinthebusinesscycle.Cashflowloanscan
helpintemporarysituations,butifcashflowproblemspersistthencompaniesneedtoimprovetheircashconversion
cycleandgetcustomerstopayfaster.
Aworkingcapitalloancanalsobeusedtofinanceeverydayoperationsofacompany.Itisnotusedtobuylongterm
assetsorinvestments,butrathertoclearupaccountspayable,paywagesandsalaries,andsoon.
Acompanycanalsopledgeitsaccountsreceivable(AR)ascollateralforaloan.Anonnotificationloanisatypeof
fullrecourseloanthatissecuritizedbyaccountsreceivable.Customersmakingaccountsreceivablepaymentsarenot
notifiedthattheiraccount/paymentisbeingusedascollateralforaloan.Theycontinuemakingpaymentstothe
companythatrenderedservicesormadetheoriginalloan,andthecompanythenusesthosepaymentstorepaytheir
lenderforfinancingobtained.Ifcustomersdonotpayaccountsreceivable,thecompanyisstillliableforrepayingthe
loanitobtainedusingtheARassecurity.
Abridgeloan,alsoknownas"interimfinancing,""gapfinancing"ora"swingloan,"isashorttermloanthatisused
untilacompanysecurespermanentfinancingorremovesanexistingobligation.Thistypeoffinancingallowstheuser
tomeetcurrentobligationsbyprovidingimmediatecashflow.Theloansareshortterm(uptooneyear)withrelatively
highinterestratesandarebackedbysomeformofcollateralsuchasrealestateorinventory.
Asthetermimplies,theseloans"bridgethegap"betweentimeswhenfinancingisneeded.Theycanbecustomizedfor
manydifferentsituations.Forexample,let'ssaythatacompanyisdoingaroundofequityfinancingthatisexpectingto
closeinsixmonths.Abridgeloancouldbeusedtosecureworkingcapitaluntiltheroundoffundinggoesthrough.
Thisisnotanexhaustivelistofthetypesofloansavailabletobusinesses,butitgivesageneralideaofthedifferent
optionsavailable.Businessesshouldshoparoundatdifferentinstitutionstodeterminewhichlenderoffersthebest
termsfortheloan.

LoansAndAmortizationAmortization
Therearetwotypesofamortization.Onerelatestothewaycertainbusinessexpensesarededucted,whichwediscussed
inSection2.Theotherrelatestothewayaloanisrepaid,whichwe'lldiscusshere.Amortizationdescribesthepaying
offofdebtinregularinstallmentsoveraperiodoftime.Anamortizedloanhasscheduledperiodicpaymentsofboth
principalandinterest.Withaselfamortizingloan,theperiodicpaymentsconsistofbothprincipalandinterestinan
amountsuchthattheloanwillbepaidoffbytheendofascheduledterm.Assumingtheloanisafixedrateloan,the
amountofeachpaymentandthebreakdownoftheprincipalandtheinterestthatcompriseeachpaymentcanbeknown
inadvance.Iftheloanisanadjustablerateloan,itcanstillbeselfamortizing,butbecausetheinterestrateissubjectto
change,theamountandbreakdownofeachpaymentcannotbeknowninadvance.
Borrowerswhochoosefullyamortizedloansarelesslikelytoexperience"paymentshock"thanborrowerswhochoose
loansthatarenotfullyamortized.Paymentsonloansthatarenotinitiallyfullyamortizedmustatsomepointbecome
amortizedovertheremainingtermoftheloaninorderfortheoutstandingprincipalbalancetoberepaid.Theshorter
theremainingterm,thelargertheincreaserequiredintheperiodicpaymentstoamortizetheloanovertheremaining
term.
Withafullyamortizingloan,theprincipalbalancedecreaseswitheachpayment.Withanegativelyamortizingloan,the
principalbalanceincreaseseachmonthbecausethepaymentsfailtocovertheinterestdue.Theunpaidinterest,called
"deferredinterest,"isaddedtotheloan'sprincipal,whichultimatelycausestheborrowertoowemoremoney.
Forexample,consideraloanwithan8%annualinterestrate,aremainingprincipalbalanceof$100,000,anda
provisionthatallowstheborrowertomake$500paymentsatacertainnumberofscheduledpaymentdates.Theinterest

dueontheloanatthenextscheduledpaymentwouldbe:0.08/12x100,000=$666.67.Iftheborrowermakesa$500
payment,$166.67indeferredinterest($666.67$500)willbeaddedtotheprincipalbalanceoftheloanforatotal
remainingprincipalbalanceof$100,166.67.Thenextmonth'sinterestchargewouldbebasedonthisnewprincipal
balanceamount,andthecalculationwouldcontinueeachmonthleadingtoincreasesintheloan'sprincipalbalanceor
negativeamortization.
Negativeamortizationcannotcontinueindefinitely.Atsomepoint,theloanmuststarttoamortizeoveritsremaining
term.Typically,negativelyamortizingloanshavescheduleddateswhenthepaymentsarerecalculated,sothattheloan
willamortizeoveritsremainingterm,ortheyhaveanegativeamortizationlimitwhichstatesthatwhentheprincipal
balanceoftheloanreachesacertaincontractuallimitthepaymentswillberecalculated.
Withanonamortizingloan,paymentsontheprincipalarenotmade,whileinterestpaymentsorminimumpaymentsare
maderegularly.Asaresult,thevalueofprincipaldoesnotdecreaseatalloverthelifeoftheloan.Theprincipalisthen
paidasalumpsumatthematurityoftheloan.Examplesofnonamortizingloanagreementsareballoonmortgagesand
deferredinterestprograms.
Anamortizationscheduleisachartshowingacompletebreakdownofperiodicblendedloanpayments.Itshowsthe
amountofprincipalandtheamountofinterestthatcompriseeachpaymentsothattheloanwillbepaidoffattheendof
itsterm.Earlyintheschedule,themajorityofeachperiodicpaymentisinterest.Laterintheschedule,themajorityof
eachperiodicpaymentisputtowardtheprincipal.
Ifyouknowthetermofaloanandthetotalperiodicpayment,aneasywaytocalculateanamortizationscheduleisto
dothefollowing:Startinginmonthone,multiplytheloanbalancebytheperiodicinterestrate.Thiswillbetheinterest
amountofthefirstmonth'spayment.Subtractthatamountfromthetotalpayment,whichwillgiveyoutheprincipal
amount.
Tocalculatethenextmonth'sinterestandprincipalpayments,subtracttheprincipalpaymentmadeinmonthonefrom
theloanbalance,andthenrepeatthestepsfromabove.
Asanalternative,youcanletaloanamo