The real cost of a loan often is hidden in the details

On the Money
From the December 6, 2002 print edition

To paraphrase a famous nursery rhythm; “This little piggy went to market, this little piggy stayed home, this little piggy had roast beef, this little piggy had none, and THIS little piggy went wee, wee, wee-all the way to the bank!”

The last piggy worked for the pig that “had roast beef” who loaned it to the piggy that “had none.” And that little piggy had made an 89 percent annualized return on her money, even though the interest rate was “only” 10.5 percent per year.

How did this happen? Let’s dissect the transaction and discover how the real cost of a loan (and the genuine profit to the lender) is not always what it might seem.

From the borrower’s perspective, the essential calculation for cost-of-money is based upon how much cash changed hands-not annual interest rate, accrued expenses, opportunity cost, amortized liability, or any other finance-industry term. In plain English, how much cash did you get for how much you gave back to the little piggy– oops, lender?

Let’s take a $100 example. You have no roast beef and wish to borrow $100 for one year. You find the little piggy with the beef and strike a deal. “You’re a risky looking pig,” says the beef-keeper. “The interest rate will be 10.5 percent per year.”

Not exactly “prime,” but nevertheless you agree. You start listing the costs associated with this loan, beginning with $10.50 interest costs.

Also, you get pay an “origination fee.” This is a fee (read up-front profit to the lender), for instigating this loan, even though you approached the lender. Origination fee: 3 percent, or $3.00. Instead of getting $100, you only receive $97.

Other items that appear in the form of fees that add to the real cost of funds by reducing the amount of cash you will receive include:

Original Issue Discount – Another creative term that represents nothing but additional return to the lender; in our example, another 2 percent or $2.00.

Processing fee – You get to pay for the lender’s secretarial and administrative support.

Filing fee – Once again, this item is a way for the lender to pass on their cost of doing business to you.

Account servicing fee – This is the lender’s cost of keeping track of you and your payments. These three fees, for example, are $10.

Note: If you can imagine ANY possible fee, the lender may attach it. Examples include: EPA Report Costs, Closing Fees, and Document Preparations, just to name a few. For our discussion, let’s say these fees add up to $5

In most cases the fees mentioned above are deducted from what you will receive as “loan proceeds;” the cash you obtain. However, application fees are usually accepted up-front. You have the privilege of giving some of what you want to the person who already has it. In our example, let’s use $5.

Pre-payment, which can be tricky, must be dealt with. In our example the lender is expecting to receive 10.5% interest at the end of one year. Logic says that if you can repay your loan early, do so. However, there may be a pre-payment penalty. Sometimes the “penalty” is stated as a percent of the balance at the time of the pre-payment. In other situations it can be hidden within amortization schedules.

The lender may present one amortization schedule for regular payments, but if the loan is pre-paid another schedule is used so that the lender will still receive the same dollar amount of interest as if they had been at risk the entire time.

Let’s assume the loan is paid off at 6 months but due to either a pre-payment penalty or double amortization schedule the lender still gets the full 10.5% ($10.50) even though the money was only at risk for half of that time.

Let’s conduct a tally. The piggy with the beef gave the one with none $80.00- that’s $100 less $3 origination fee, $2 original issue discount, $10 original issue, processing and filing fee, and $5 other fees. After 6 months, the lender receives $115.50- $100 principal, $10.50 in interest and the $5 application fee. On a cash basis, the profit is $115.50 minus $80 equaling $35.50. That’s a 44.4% return on the cash money. And, since the loan was paid in only 6 months, the annualized return is 88.8 percent!

Generally, it is illegal to realize more than 45% profit from lending. If the profit is more than 45percent, it’s called usury– an area that is complex and filled with legal subtleties.

Nevertheless, when borrowing money, take a moment to conduct a cash-on-cash analysis to determine the authentic cost of the loan.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.