Question

A firm owner Liam meets his banker Mary to work out the details on a one-year loan. Explain their thinking and all the relevant terms, such as the nominal and real interest rate, expected inflation etc.

Answer 1

Liam meets his banker Mary to work out the details on a one year loan. There are many factors they will have to think about before taking the loan.

1. Need- First, they will have to think about the right amount of loan that is to be undertaken. They will discuss the cause of taking the loan. After that they will go ahead to factor in other details.

2. Cost consideration- Taking a loan does not only entail the loan amount. There are several other costs associated with it such as processing fees, pre-payment fees, late payment fees. So, they will have to consider the various fees that the lenders will charge to get an estimate of the total loan amount.

3. Credibility of the lender- Loans should be taken from a reliable source.

4. Loan process- Most banks requure to submit many documents and its verification before the initiation of the loan process. So, Liam and Mary will have to think about this too.

5. Interest rate- One of the major factor to be considered is the interest rate. For repayment of the loan, Liam will have to repay the principal amount of the loan as well as the interest rate amount.

Say, Rs. 10000 is the loan amount and rate of interest is 5% p.a. and loan was undertaken for one year. Then the interest rate amount will be Rs. [10000* (5/100)] = Rs. 500.

The principal loam amount is Rs. 10000. So, after one year repayment amount is Rs. (10000+500) = Rs. 10500.

Now, interest rate can be of two types, nominal interest rate and real interest rate.

Real interest rate is adjusted to remove the effect of inflation and thereby reflects the real cost of fund to borrower and so is a much reliable rate. On the other hand, nominal interest rate is not adjusted for the effect of inflation and so is not a reliable form of interest rate to be associated with while considering taking a loan.

6. Inflation- It is defined as the rise in price level of commodity which results in falling of purchasing power and thereby a fall in value of money. While considering taking a loan, inflation will prove to profitable to a borrower ( in this case, Liam). This happens because as the value of money falls, Liam will pay the lender back money which is worth less than when he actually borrowed it one year back.

So exoected inflation will prove to be a driving force for Liam to take the loan.

7. Repayment period - Since Liam wants to take a loan for one year, he will consider the loans from lenders for which the repayment period is after one year.