About Loans Info

The easiest way to signal a banker that you are clueless about loans and finance (and, therefore, incapable of managing a business) is to march into a bank office and request the wrong type of loan. This is a subject area where the adage "just enough knowledge to be dangerous" applies to the loan application process.

The principle to which bankers adhere in establishing loan terms or amortizations is to match the repayment period of a loan to the useful life of the asset that is acquired by the loan proceeds or the asset that secures the loan. This theme is evident throughout the following discussion.

Short-Term Loans

Short-term loans are loans of one year or less in duration. The underlying assets associated with these loans are typically current assets like cash, accounts receivable, and inventory. Lines of credit, construction loans, floor plans, and regular loans with durations of twelve months or less fall into this category.

Until the 1970s, most short-term loans were structured as thirty, sixty, or ninety-day loans that required all principal and interest to be paid at maturity. Nearly every industry had cyclical periods every year when sales peaked. If a company planned ahead, it might borrow money for a brief period in order to increase inventory in anticipation of the annual spike in sales.

Conversely, a company might need to borrow money shortly after the peak in sales because all its working capital was invested in accounts receivable. The first company would repay the loan with cash proceeds from sales and the second company would repay the loan from collections of accounts receivable.

Businesses experienced profound fundamental changes during the 1980s as computers, unabashed consumerism, and access to worldwide markets supercharged our economy. Companies no longer experienced annual peak periods of sales activity. Sales either were maintained at a higher baseline or continued to climb to new heights.

Banks found that they were renewing thirty-day notes over and over again. The processing of a loan costs banks a lot of money, and renewals of existing loans are not any less expensive than originating a new loan. It did not take them long to find a more efficient way of providing for the short term loan needs of their clients: lines of credit.

Your Retirement Plan

These days, many employees have built up considerable sums in company retirement plans, including 401(k) plans, 403(b) plans and company profit-sharing plans. The average 401(k) account holds $30,000, and close to 10% of all accounts top six digits. Should you tap that retirement kitty to pay for your kids' college education?

Maybe. But even if your plan has an attractive sounding interest rate, and even though the interest you pay winds up in your own account, a home-equity loan is almost certain to be cheaper, if you can get one. The discussion in the next section will show why. But first, bear in mind that not all retirement plans permit loans:

·  Defined-benefit plans-those that guarantee set payments based on your salary and years of service-almost never allow loans. The law doesn't allow you to borrow from your IRA, or from SEP-IRAs or Keogh accounts, which are retirement plans for the self-employed.

In plans that do permit borrowing, there are federal limits (under the Employee Retirement Income Security Act) on how much of your account you can tap. You can borrow only up to 50% of your vested balance, which is the amount that's yours to roll over if you quit your job, but no more than $50,000.

More Expensive Than Meets the Eye

A typical interest rate is the prime rate plus one percentage point and, yes, you pay yourself the interest. But that doesn't make it the free loan it may sound like. In most cases, when you borrow from your retirement plan you in effect realign the investments inside your account. Rather than having the amount of the loan, say $15,000, in your 401(k)'s stock mutual fund, for example, you have it invested in a college loan.

If the interest rate on the loan is 7%, that's what that portion of your retirement money earns while the loan is outstanding. When investments inside the plan are growing at a higher rate than interest charged on the loan, the "bargain loan" rate is deceptive.

Here's why: Say, for example, that your 401(k) investments are growing at 12% a year. Borrowing from the plan at 7% means not only paying the 7% out of your pocket but also forfeiting the 5% difference between that rate and the 12% the money would otherwise be earning. So 12%-not 7%-is the rate to compare with the cost of borrowing elsewhere.

A retirement plan loan is a good choice if your 401(k) money is earning less than the going rate on plan loans. In that case, you get a convenient, below-market-cost loan, plus you boost the return on your retirement investments.

If you've got your money in a guaranteed investment contract (GIC) that's paying 5%, for example, and you pay off retirement, you shouldn't have your retirement money in GICs, your retirement stash is spread among various investments, such as GICs, bonds and stocks, see if you can borrow first from the portion earning the lowest return. That keeps the cost of the loan as low as possible. 

Margin Loans

Borrowing "on margin," or against the value of a stock or bond portfolio, may sound like risky stuff for high finance types. That can be true when the loan is used to buy speculative investments, the value of which can rise or fall suddenly. But borrowing from your broker to pay college bills isn't necessarily risky, and it can even be a pretty good deal.

Rates, which are pegged to the "broker call rate" (what brokerages pay to borrow) are often lower than home-equity loan rates. But if you're using the money to pay college bills, the interest isn't tax-deductible, so the rate is, in effect, higher.

At most brokerages, you can borrow up to 50% of the value of the stocks or stock mutual funds in your account, and a higher percentage-often up to 85%-of the value of lower-risk investments, like Treasury bonds or municipal bonds. But it's best not to borrow up to the limit, so you can avoid the one big risk in borrowing on margin-the dreaded margin call.

If the market value of your stock falls, so does the value of the collateral backing up your loan. If the value dips below a certain point, the brokerage can demand that you pay back part of the loan or deposit extra cash or securities as collateral. If you don't have the cash, you could be forced to sell your stocks, bonds or mutual funds just after they've plummeted in value.

But if you limit your borrowing to 20% to 25% of your account value, the risk of facing a margin call is virtually nil. That's because the value of your securities would have to drop to almost nothing, which is highly unlikely unless you're in something like cattle futures, before you'd face a margin call.