Custom Search

The Cost of Bank Loans

Bank loans often extend for several years. Interest payments on these loans are sometimes fixed for the term of the loan but more commonly they are adjusted up or down as the general level of interest rates changes.

The interest rate on bank loans of less than a year is almost invariably fixed for the term of the loan. However, you need to be careful when comparing rates on these shorter term bank loans, for the rates may be calculated in different ways.

SIMPLE INTEREST

The interest rate on bank loans frequently is quoted as simple interest. For example, if the bank quotes an annual rate of 12 percent on a simple interest loan of $100,000 for 1 month, then at the end of the month you would need to repay $100,000 plus 1 month`s interest. This interest is calculated as

Amount of loan Р РЈР Р· annual interest rate = $100,000 Р РЈР Р· .12 = $1,000 number of periods in the year

Your total payment at the end of the month would be

Repayment of face value plus interest = $100,000 + $1,000 = $101,000

Earlier you learned to distinguish between simple interest and compound interest. We have just seen that your 12 percent simple interest bank loan costs 1 percent per month. One percent per month compounded for 1 year cumulates to 1.0112 = 1.1268. Thus the compound, or effective, annual interest rate on the bank loan is 12.68 percent, not the quoted rate of 12 percent.

The general formula for the equivalent compound interest rate on a simple interest loan is Effective annual rate = (1 + quoted annual interest rate)m 1 m where the annual interest rate is stated as a fraction (.12 in our example) and m is the number of periods in the year (12 in our example).

The Hazards of Secured Bank Lending

The National Safety Council of Australia`s Victoria Division had been a sleepy outfit until John Friedrich took over. Under its new management, NSC members trained like commandos and were prepared to go anywhere and do anything. They saved people from drowning, they fought fires, found lost bushwalkers and went down mines. Their lavish equipment included 22 helicopters, 8 aircraft and a mini-submarine. Soon the NSC began selling its services internationally. Unfortunately the NSC`s paramilitary outfit cost millions of dollars to run far more than it earned in revenue. Friedrich bridged the gap by borrowing $A236 million of debt. The banks were happy to lend because the NSC`s debt appeared well secured.

At one point the company showed $A107 million of receivables (that is, money owed by its customers), which it pledged as security for bank loans. Later checks revealed that many of these customers did not owe the NSC a cent. In other cases banks took comfort in the fact that their loans were secured by containers of valuable rescue gear. There were more than 100 containers stacked around the NSC`s main base. Only a handful contained any equipment, but these were the ones that the bankers saw when they came to check that their loans were safe. Sometimes a suspicious banker would ask to inspect a particular container. Friedrich would then explain that it was away on exercise, fly the banker across the country in a light plane and point to a container well out in the bush. The container would of course be empty, but the banker had no way to know that.

Six years after Friedrich was appointed CEO, his massive fraud was uncovered. But a few days before a warrant could be issued, Friedrich disappeared. Although he was eventually caught and arrested, he shot himself before he could come to trial. nvestigations revealed that Friedrich was operating under an assumed name, having fled from his native Germany, where he was wanted by the police. Many rumors continued to circulate about Friedrich. He was variously alleged to have been a plant of the CIA and the KGB and the NSC was said to have been behind an attempted countercoup in Fiji. For the banks there was only one hard truth. Their loans to the NSC, which had appeared so well secured, would never be repaid.