Agribusiness Library LESSON L060019: THE CONCEPT OF BORROWING MONEY

Objectives 1. Explain reasons for and types of borrowing. 2. Describe what a lender looks for in a borrower, and identify the common components of a lending/credit application. 3. Describe characteristics that borrowers should look for in lenders. 4. Explain how credit works.

Terms Assets Character Collateral Credit rating Default Interest Intermediate-term loan Lender Liabilities Loan security Long-term loan Short-term loan

 Usually at some point in the operation of a business, there will be a need to borrow money.  An individual may borrow money to buy or start a business, expand an existing business, purchase new supplies and equipment, or hire new employees.  Depending on the reason for the loan, several loan types are available to the business owner.

 A. A short-term loan is money that is typically repaid within one year.  These loans have lower interest rates and are generally used to purchase items that are needed for the immediate operation of the business.  Examples of items that are purchased with short-term loans include supplies, inventory, fuel, seed, fertilizer, and livestock feed.

 B. An intermediate-term loan is money that is typically repaid between one and ten years later.  These types of loans are normally used to purchase machinery or other equipment, but they may also be used for small business expansions.

 C. A long-term loan is money that is repaid over a period of time, typically more than 10 years.  Long-term loans are used to make large purchases (e.g., property or real estate) or to make substantial improvements or expansions to an existing business.  Long-term loans usually have the highest interest rates because of the length of time for repayment, along with the economic uncertainty of the future.

 A lender is an institution or individual who loans money.  For most people, lending institutions include banks, credit unions, or other companies that offer loans.  While lending institutions make a profit from loaning individuals money, they carefully screen all loan applicants to select people with the ability to repay the loan.  Having an individual default (stop paying) on a loan causes hardships for the individual and the lending institution.

 A. Lenders will examine the character (reputation) of the borrower before deciding to issue the loan.  Lenders may ask borrowers to provide a list of people who can be contacted to establish the character of the borrower.

 B. The financial position of the borrower is also important.  The amount of the loan is partially based on the current economic state of the borrower.  In other words, the bank will want to know how much money you currently have, a list of any assets (items of value that are owned) and a list of any liabilities (debts).  If the borrower is significantly in debt already, the lender will be hesitant to loan the individual more money.

 C. A borrower must prove the capacity to repay the loan.  Lenders may require the borrower to provide a copy of a recent pay stub for proof of employment and verification of the monthly income amount.  The lender may also ask for a monthly budget to review the current spending habits and income of the borrower.

 D. Loan security —the ability of the lender to recover the money if the loan is not repaid—is another consideration.  To secure the loan, borrowers are sometimes asked to pledge collateral (property or other items of value that will be seized by the lender if the loan is not repaid).  Real estate and vehicles usually act as collateral for home mortgages and car loans.

 Just as lenders research the borrower before making the loan, a borrower should thoroughly research the lender before applying for a loan.  Before entering into any type of loan contract, a borrower must feel comfortable with and trust the lender.  A. A lender should be a business of high quality and outstanding character.  Borrowers should educate themselves on the reputation of the lender in the community by talking to relatives, friends, and other business owners.  A borrower can also check with the Better Business Bureau in the community to research any past complaints made against the lender.

 B. After examining character, the institution’s lending policies should be examined.  Knowing the person handling the loan, the name of the person to contact in case of questions, the policies for late payments, and the loan fees is part of being an informed borrower.  Some loans, including most mortgage loans, may require insurance as part of the contract.  As a result, the loan processing fees may be increased.

 C. The permanence of the lending institution should be considered.  Permanence refers to the length of time the institution has been in operation and its ability and the likelihood of it remaining in operation for the life of the loan.  If the loan office is operating out of a building that was a fast food restaurant a year ago, it is probably not the best choice for borrowers.

 D. The cost of the loan is another consideration.  Every loan has a cost associated with borrowing money.  Banks and other lenders charge borrowers interest (a fee charged on the amount of money that is lent).  Interest is how lending institutions make a profit on issuing loans.  Not all institutions have the same interest rates, and some loans may have provisions that increase the interest rate in the event of a missed or late payment.  Being informed about all interest rates and policies can help borrowers make better decisions about potential lenders.

 Before a lending institution loans money, it requires the individual seeking funds to provide proof of the ability and willingness to repay the loan and interest amount.  Lenders will often check an individual’s credit rating to determine if the borrower is a safe risk.  The higher the individual’s credit rating number, the safer the risk.

 A. Steps can be taken to obtain a good credit rating —a measure of an individual’s or company’s ability to repay a debt.  A credit rating is, in part, determined on the borrower’s debt payment history.  Therefore, an individual who has never had debt will generally not have a good credit rating.  Lenders will want proof that a person can take on debt and successfully make long-term plans and payments to repay the full loan amount.  Borrowers can improve their credit ratings.

 1. One of the easiest ways to begin building credit is to open a checking or savings account and use it successfully.  By managing even a small account, the borrower will show lenders that he or she can budget and save money, proving the ability to repay a loan.  Writing bad checks (checks for more than the amount you have in your checking account) will lower your credit rating and make you more unlikely to receive a future loan.  2. Another way to build credit is to buy an item on a payment plan to show the willingness to pay.  By successfully making small payments, month after month, a borrower can prove his or her willingness to repay the loan.

 3. Using credit cards is another way to build credit, as long as the cards are used wisely and with caution.  a. If an individual has a few credit cards, uses them to make purchases, and pays off the full amount each month, it will show lenders that the person understands the concept of borrowed money and the responsibility to repay loans.  b. Improper use and the mounting of serious credit card debt can ruin your credit rating more quickly than good credit can be established.  A good rule of thumb is that if you cannot fully pay off the charges on your card each month, stop using the card until it is paid.

 B. When difficulties are encountered in paying bills in a timely manner, it is best to contact the lender to discuss alternative repayment plans.  Lenders do not like borrowers to miss payments any more than the borrowers do.  It is best to avoid all surprises with your lenders and to keep them informed of any changes in your financial situation.  Some lenders may provide grace periods if a sudden illness or loss of employment occurs.

 C. If the lending institution believes there is not sufficient proof of an individual’s ability to repay a loan, it may require a cosigner—someone who shows the ability or collateral to secure the loan and will be responsible for the loan should the first individual be unable to repay it.  Cosigners are often needed on loans made to first-time homebuyers because they do not have the collateral or the history to prove sufficient loan repayment.

REVIEW What are the reasons for and types of borrowing? What characteristics would a lender look for in a borrower, and what information might be requested on a loan application? What characteristics should lenders have? How does credit work?