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To be honest I struggled with how to title and explain parts of this course when explaining banking

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words.

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I wanted to call them banking terms but the word term has a special technical definition in lending.

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In fact I'm going to show you how you may have a single loan with multiple types of terms in lending.

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The word term refers to a period of time commercial real estate loans often have three types of loan

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terms a repricing term a balloon term and an amateur ization term so in lending the word term refers

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to a period of time business loans often have three types of loan terms are repricing term a balloon

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term and an average ization term.

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Let's look at each the repricing term as how frequently your loan rate changes for floating rate loans.

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The interest rate changes whenever the index rate changes.

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When I worked at banks we went into a mad scramble whenever the Fed changed the fed funds rate because

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it causes the prime rate to change.

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We had to update our systems that day and make sure customers were charged the correct floating rate

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at the other end of the spectrum or fixed rate loans.

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They don't have a repricing term variable rate loans lie somewhere between floating rate loans whose

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rate can change any day and fixed rate loans that never change the rate on a variable rate loan can

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change once a month once a quarter once a year or every few years based on the loan agreement.

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The balloon term is when the remaining principal is due.

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You may understand this better if I explain it with an example.

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Let's assume you have a loan with a 10 year balloon term.

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You would make periodic PMI payments for 10 years.

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The monthly principal portions of your loan payments are reducing your principal balance over time.

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At the end of the tenth year of your loan the whole amount of any unpaid principal is due.

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It might be a large amount.

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You may be wondering why the loan wouldn't be set to gradually pay down to zero by the end of the tenth

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year.

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That's because many business loans have amortization terms that are longer than their balloon terms.

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I'll explain that next.

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The Amitai ization term is the length of time it would take to pay the loan to zero at your loan payment.

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So let's go back to our 10 year balloon loan term.

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If it has a 25 year Amman ization term it would take twenty five years to pay the principal down to

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zero at the 10 year point when the balloon term ends.

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You still have a good chunk of unpaid principal balance.

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I'll explain this with the picture I'm going through this detail on loan terms because commercial real

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estate loans often have different repricing terms.

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Balloon terms and amortization terms the terms in this graph were one of the most common if not the

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most common structure of commercial real estate terms at banks I worked at.

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That structure is a set of two five year repricing terms with a 10 year balloon term and a twenty five

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year amortization term.

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You may hear lenders talk about a twenty five year ARM which means a twenty five year amortization term.

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The solid line in the graph is the principal balance of the loan.

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The dotted line is what the principal balance would have been if the balloon payment wasn't due at the

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end of the tenth year looked down at the bottom left quadrant of the graph.

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The bottom two sets of arrows show the two five year repricing terms.

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All the principal is due in the tenth year which is why the principal balance which the solid line goes

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from over eight hundred thousand dollars to zero in year 10.

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Notice that the balloon term is 40 percent of the amortization term.

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If you calculate it as 10 years divided by twenty five years however the principal balance is paid down

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less than 20 percent during those 10 years.

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The principal reduction of advertising loans starts slowly and then increases during the loan.

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You can see this in the arc of the solid line leading to the dotted line.

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The amortization term the payment amount is set so that if you would have kept making the same total

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payment dollar amount and rates never changed and you didn't have a balloon payment your last payment

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at year twenty five would pay the principal balance to zero.

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Leave it to bankers to make a loan that's this complicated.

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Why do bankers do this.

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The answer is to give business customers what they want.

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As a recovering banker let me try to explain for my former co-workers the longer the repricing term

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the higher the interest rate market rates like Treasury rates usually increase with longer terms due

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to the higher risk and uncertainty there's the risk that inflation will be higher in the future rates

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will increase for some other reason.

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The sources of funding for a bank increase with longer terms and the price they charge to borrowers

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increases with longer terms so borrowers often choose 5 year or even 3 year repricing terms to reduce

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their interest rate and interest expense.

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That explains why repricing terms are a few years.

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But why is the balloon term shorter than the amortization term.

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The shorter the balloon term the lower the interest rate.

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The cash comes back sooner to the bank which reduces risk and discount rates so banks can pass those

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savings on to the borrower.

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Another way banks profitability improves with balloon terms is because larger loans are cheaper for

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banks to service efficiency increases with loan size.

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A bank servicing lots of small loans near the end of their amortization periods would have to pass along

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the cost of that inefficiency to borrowers be a higher interest rates.

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Okay then why is the Ammad ization period so long.

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Why is it longer than the balloon term.

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The longer the amortization term the lower the total monthly payment each month the monthly payment

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for a million dollar loan at 7 percent interest with a 25 year amortization is seven thousand sixty

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seven dollars short in that amortization term to ten years and the payment goes up to eleven thousand

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six hundred eleven dollars an increase of four thousand five hundred and forty four dollars or sixty

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four percent.

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Businesses usually take out loans because cash is tight or they need the cash for other purposes.

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These businesses want longer amortization periods to reduce the monthly cash burden of the loan payments.

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Having an advertiser Asian term that's longer than your balloon term does create an event for which

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you need to prepare the big balloon payment at the end of your 10 businesses generally do one of two

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things.

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If they have lots of cash at the end of the balloon term they may pay off the loan and be done.

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Many businesses take out a new loan at the balloon term.

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This loan may be larger than their original loan because the value of the collateral the real estate

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has gone up and they want to tap into that cash before we go into the next section on different types

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of loans.

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I want to cover why you should match the term of your loans to cash flows.

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If you borrow from a short term line of credit a credit card for equipment or real estate you will need

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to pay back those loans long before the acid has had time to earn cash for you to pay back the loan.

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This would cause a cash crunch also called a liquidity crisis.

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Use short term financing for short term needs and longer term financing for equipment and real estate

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however even current assets may give rise to long term financing needs.

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One example is permanent working capital.

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Working capital is the difference between your current assets and your current liabilities.

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Permanent working capital increases when receivables rise and won't go back down and until production

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goes down which may be very very far in the future.

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If ever your receivables are constantly some portion of your sales when your sales increase your receivables

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increase and they won't decrease until your sales decrease.

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This is part of the funding needed for growth that companies don't anticipate increases in permanent

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working capital need funded with long term debt or equity.