Personal Finance Example 16.10

Megan Schwartz has been approved by Clinton National Bank for a 180-day loan of $30,000 that will allow her to make the down payment and close the loan on her new condo. She needs the funds to bridge the time until the sale of her current condo, from which she expects to receive $42,000.

Clinton National offered Megan the following two financing options for the $30,000 loan: (1) a fixed-rate loan at 2% above the prime rate or (2) a variable-rate loan at 1% above the prime rate. Currently, the prime rate of interest is 8%, and the consensus forecast of a group of mortgage economists for changes in the prime rate over the next 180 days is as follows:

  • 60 days from today the prime rate will rise by 1%.
  • 90 days from today the prime rate will rise another 1 over 2%.
  • 150 days from today the prime rate will drop by 1%.

Using the forecast prime rate changes, Megan wishes to determine the lowest interest-cost loan for the next 6 months.

  • Fixed-Rate Loan: Total interest cost over 180 days
  • Variable-Rate Loan: The applicable interest rate would begin at 9% (8% + 1%) and remain there for 60 days. Then the applicable rate would rise to 10% (9% + 1%) for the next 30 days and then to 10.50% (10% + 0.50%) for the next 60 days. Finally, the applicable rate would drop to 9.50% (10.50% − 1%) for the final 30 days.

Total interest cost over 180 days

Because the estimated total interest cost on the variable-rate loan of $1,442 is less than the total interest cost of $1,480 on the fixed-rate loan, Megan should take the variable-rate loan. By doing so, she will save about $38 ($1,480 − $1,442) in interest cost over the 180 days.

Lines of Credit

line of credit is an agreement between a commercial bank and a business, specifying the amount of unsecured short-term borrowing that the bank will make available to the firm over a given period of time. It is similar to the agreement under which issuers of bank credit cards, such as MasterCard, Visa, and Discover, extend preapproved credit to cardholders. A line-of-credit agreement is typically made for a period of 1 year and often places certain constraints on the borrower. It is not a guaranteed loan; rather, it indicates that if the bank has sufficient funds available, it will allow the borrower to owe it up to a certain amount of money. The amount of a line of credit is the maximum amount the firm can owe the bank at any point in time.

line of credit

An agreement between a commercial bank and a business specifying the amount of unsecured short-term borrowing the bank will make available to the firm over a given period of time.

When applying for a line of credit, the borrower may be required to submit such documents as its cash budget, pro forma income statement, pro forma balance sheet, and recent financial statements. If the bank finds the customer acceptable, the line of credit will be extended. The major attraction of a line of credit from the bank’s point of view is that it eliminates the need to examine the creditworthiness of a customer each time it borrows money within the year.

Interest Rates The interest rate on a line of credit is normally stated as a floating rate: the prime rate plus a premium. If the prime rate changes, the interest rate charged on new as well as outstanding borrowing automatically changes. The amount a borrower is charged in excess of the prime rate depends on its creditworthiness. The more creditworthy the borrower, the lower the premium (interest increment) above prime and vice versa.

Operating-Change Restrictions In a line-of-credit agreement, a bank may impose operating-change restrictions, which give it the right to revoke the line if any major changes occur in the firm’s financial condition or operations. The firm is usually required to submit up-to-date, and preferably audited, financial statements for periodic review. In addition, the bank typically needs to be informed of shifts in key managerial personnel or in the firm’s operations before changes take place. Such changes may affect the future success and debt-paying ability of the firm and thus could alter its credit status. If the bank does not agree with the proposed changes and the firm makes them anyway, the bank has the right to revoke the line of credit.

operating-change restrictions

Contractual restrictions that a bank may impose on a firm’s financial condition or operations as part of a line-of-credit agreement.

Compensating Balances To ensure that the borrower will be a “good customer,” many short-term unsecured bank loans—single-payment notes and lines of credit—require the borrower to maintain, in a checking account, a compensating balance equal to a certain percentage of the amount borrowed. Banks frequently require compensating balances of 10 to 20 percent. A compensating balance not only forces the borrower to be a good customer of the bank but may also raise the interest cost to the borrower.

compensating balance

A required checking account balance equal to a certain percentage of the amount borrowed from a bank under a line-of-credit or revolving credit agreement.

Example 16.11

My Finance Lab Solution Video

Estrada Graphics, a graphic design firm, has borrowed $1 million under a line-of-credit agreement. It must pay a stated interest rate of 10% and maintain, in its checking account, a compensating balance equal to 20% of the amount borrowed, or $200,000. Thus, it actually receives the use of only $800,000. To use that amount for a year, the firm pays interest of $100,000 (0.10 × $1,000,000). The effective annual rate on the funds is therefore 12.5% ($100,000 ÷ $800,000), which is 2.5% more than the stated rate of 10%.

If the firm normally maintains a balance of $200,000 or more in its checking account, the effective annual rate equals the stated annual rate of 10% because none of the $1 million borrowed is needed to satisfy the compensating-balance requirement. If the firm normally maintains a $100,000 balance in its checking account, only an additional $100,000 will have to be tied up, leaving it with $900,000 of usable funds. The effective annual rate in this case would be 11.1% ($100,000 ÷ $900,000). Thus, a compensating balance raises the cost of borrowing only if it is larger than the firm’s normal cash balance.

Annual Cleanups To ensure that money lent under a line-of-credit agreement is actually being used to finance seasonal needs, many banks require an annual cleanup. In these cases, the borrower must have a loan balance of zero—that is, owe the bank nothing—for a certain number of days during the year. Insisting that the borrower carry a zero loan balance for a certain period ensures that short-term loans do not turn into long-term loans.

annual cleanup

The requirement that for a certain number of days during the year borrowers under a line of credit carry a zero loan balance (that is, owe the bank nothing).

All the characteristics of a line-of-credit agreement are negotiable to some extent. Today, banks bid competitively to attract large, well-known firms. A prospective borrower should attempt to negotiate a line of credit with the most favorable interest rate, for an optimal amount of funds, and with a minimum of restrictions. Borrowers today frequently pay fees to lenders instead of maintaining deposit balances as compensation for loans and other services. The lender attempts to get a good return with maximum safety. Negotiations should produce a line of credit that is suitable to both borrower and lender.

Revolving Credit Agreements

revolving credit agreement is nothing more than a guaranteed line of credit. It is guaranteed in the sense that the commercial bank assures the borrower that a specified amount of funds will be made available regardless of the scarcity of money. The interest rate and other requirements are similar to those for a line of credit. It is not uncommon for a revolving credit agreement to be for a period greater than 1 year.2 Because the bank guarantees the availability of funds, a commitment fee is normally charged on a revolving credit agreement. This fee often applies to the average unused balance of the borrower’s credit line. It is normally about 0.5 percent of the average unused portion of the line.

revolving credit agreement

A line of credit guaranteed to a borrower by a commercial bank regardless of the scarcity of money.

commitment fee

The fee that is normally charged on a revolving credit agreement; it often applies to the average unused portion of the borrower’s credit line.

Example 16.12

REH Company, a major real estate developer, has a $2 million revolving credit agreement with its bank. Its average borrowing under the agreement for the past year was $1.5 million. The bank charges a commitment fee of 0.5% on the average unused balance. Because the average unused portion of the committed funds was $500,000 ($2 million − $1.5 million), the commitment fee for the year was $2,500 (0.005 × $500,000). Of course, REH also had to pay interest on the actual $1.5 million borrowed under the agreement. Assuming that $112,500 interest was paid on the $1.5 million borrowed, the effective cost of the agreement was 7.67% [($112,500 + $2,500) ÷ $1,500,000]. Although more expensive than a line of credit, a revolving credit agreement can be less risky from the borrower’s viewpoint because the availability of funds is guaranteed.

2. Many authors classify the revolving credit agreement as a form of intermediate-term financing, defined as having a maturity of 1 to 7 years, but we do not use the intermediate-term financing classification; only short-term and long-term classifications are made. Because many revolving credit agreements are for more than 1 year, they can be classified as a form of long-term financing; however, they are discussed here because of their similarity to line-of-credit agreements.