from the desk of the CEO
Shopping for a loan is not as good an idea as one may think. This applies to business loans, real restate, residential and commercial, as well as loans for automobiles.
The issue is not that you are shopping, the issue is how you are shopping.
Let me explain.
Until a funder sees your application, neither he nor anyone else can answer any of your questions. The questions most frequently asked are, what is the interest rate and how many points will I be charged? Anyone answering these questions before seeing any of your documents, is not to be trusted and is most certainly not someone you want to conduct business with. Thousands of unscrupulous so-called lenders advertise on social media, offering rates, terms, and conditions without having ever seen any documents.
The legality of such behavior is questionable, the logic is, frankly speaking, ridiculous. Advertising flat rates, terms and conditions cannot and does not make sense and since every funding application is different one cannot generalize.
The Truth in Lending Act (TILA) was a federal law enacted in 1968 to consumers in their dealings with lenders and creditors. The TILA was implemented by the Federal Reserve Board through a series of regulations. The most important aspects of the act concern the pieces of information that must be disclosed to a borrower prior to extending credit: annual percentage rate (APR), term of the loan and total costs to the borrower. This information must be conspicuous on documents presented to the consumer before signing, and also possibly on periodic billing statements.
The TILA was implemented by the Federal Reserve Board’s enactment of Regulation Z (12 CFR Part 226). The terms within the TILA apply to most types of credit, including closed-end credit, more commonly referred to as an installment loan, and open-ended revolving credit, such as a credit card or line of credit. The regulations are designed to guard consumers against inaccurate or unfair practices on the part of the lender. Different states and industries have their own variations of TILA, but the chief feature remains the proper disclosure of key information to protect both the consumer and the lender in credit transactions.
Consumer Protections under the Truth in Lending Act
The act regulates what companies can advertise and say about the benefits of their loans or services. For example, borrowers considering an adjustable-rate mortgage must be offered specific reading materials from the Federal Reserve Board to ensure they understand the parameters of an ARM. The TILA prevents loan originators from receiving compensation for issuing mortgages where the compensation is based on the existence of certain terms and conditions within the loan documents. The TILA also forbids lenders from steering potential buyers to loans that financially benefit the lender. Instead, lenders must show potential borrowers all available, applicable loans.
Additionally, the TILA provides the right of rescission. This gives borrowers a three-day period where they can reconsider their decision and decide not to take the loan without any risk of loss to personal funds. The right of rescission allows borrowers who were subjected to high-pressure tactics to cease the proceedings. This right can be applied to any loan a consumer may pursue.
The TILA does not regulate the interest rates a lender may charge for services. Additionally, the act does not dictate to whom credit can be extended beyond standard laws against discrimination.
A borrowing base is the amount of money a lender will loan to a company based on the value of the collateral the company pledges. The borrowing base is usually determined by a method called margining, in which the lender determines a discount factor that is multiplied by the value of the collateral. The result is the amount that will be loaned to the company.
There are various assets that can be used as collateral, including accounts receivable, inventory and equipment. For example, if a company goes to a lender to borrow money, the lender will assess the company’s strengths and weaknesses, and evaluate the borrower’s risk. Based on the risk that the lending company feels is associated with the loan to the company, a discount factor of 85% may be determined. If the borrower is offering collateral that is worth $100,000, the maximum amount the lending company will give the company is equal to 85% of $100,000, or $85,000.
Why Lenders Use a Borrowing Base
With a borrowing base, lenders feel more comfortable making a loan, since it is against specific assets. The assets are typically not used to back other loans, or the lenders will have the first claim. They may even extend more credit under this formula.
The borrowing base can be adjusted downward, protecting the lender. If the value of the collateral falls, the credit limit also declines. Should the collateral increase, the borrowing base will also rise, up to a predetermined limit.
The borrower must provide the lender with certain information to determine the borrowing base. This includes information on sales and collections, along with inventory. Middle-market and large asset-based loans generally require the borrower to give the lender a certificate with detailed calculations, such as which receivables are eligible, if the borrowing base is determined this way. The certificate is delivered periodically, which is spelled out in the credit agreement.
Lenders conduct regular investigations. This involves checking the borrower’s business and having an appraiser value the collateral that is used in calculating the borrowing base. This is commonly known as due diligence.
A Real Life Example
Cabot Oil & Gas Corporation did not have any borrowings outstanding under its revolving credit facility as of March 31, 2016. However, its borrowing base is redetermined annually on April 1. The company or banks may request a redetermination semi-annually, or whenever Cabot acquires or sells oil and gas properties. On April 19, 2016, the borrowing base was lowered to $3.2 billion from $3.4 billion.
Credit risk refers to the risk that a borrower may not repay a loan and that the lender may lose the principal of the loan or the interest associated with it. Credit risk arises because borrowers expect to use future cash flows to pay current debts; it’s almost never possible to ensure that borrowers will definitely have the funds to repay their debts. Interest payments from the borrower or issuer of a debt obligation are a lender’s or investor’s reward for assuming credit risk.
When lenders offer borrowers mortgages, credit cards or other types of loans, there is always an element of risk that the borrower may not repay the loan. Similarly, if a company offers credit to its client, there is a risk that its clients may default. Credit risk also describes the risk that a bond issuer may fail to make payment when requested or that an insurance company won’t be able to make a claim.
How Is Credit Risk Assessed?
Credit risks are calculated based on the borrowers’ overall ability to repay. To assess credit risk on a consumer loan, lenders look at the five C’s: an applicant’s credit history, his capacity to repay, his capital, the loan’s conditions and associated collateral.
Similarly, if an investor is thinking about buying a bond, he looks at the credit rating of the bond. If it has a low rating, the company or government issuing it has a high risk of default. Conversely, if it has a high rating, it is considered to be a safe investment. Agencies such as Moody’s and Fitch evaluate the credit risks of thousands of corporate bond issuers and municipalities on an ongoing basis.
For example, if an investor wants to limit his exposure to credit risk, he may opt to buy a municipal bond with a AAA rating. In contrast, if he doesn’t mind a bit of risk, he may buy a bond with a lower rating in exchange for the potential of earning more interest.
How Does Credit Risk Affect Interest Rates?
If there is a higher level of perceived credit risk, investors and lenders demand a higher rate of interest for their capital. For example, if a mortgage applicant has a stellar credit rating and a steady income flow from a stable job, he is likely to be perceived as a low credit risk and will receive a low interest rate on his mortgage. In contrast, if an applicant has a lackluster credit history, he may have to work with a subprime lender, a mortgage lender that offers loans with relatively high interest rates to high-risk borrowers.
Similarly, bond issuers with less than perfect ratings offer higher interest rates than bond issuers with perfect credit ratings. The issuers with lower credit scores need to use high returns to entice investors to take a risk on their bonds.
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