Loan Structure
November 3, 2022
What is Loan Structure？
Companies borrow money from banks or other financial institutions for a variety of purposes. They might need additional working capital, for example, or wish to purchase new equipment, pursue expansion plans, acquire another company, or meet unexpected expenses. A borrower repays the loan with interest over a predetermined period called the term of the loan. Loan structure refers to the constituent parts of the loan, such as the purpose, amount, type, interest rate, repayment term, and repayment method. The structure also includes measures to mitigate risk, and may include requirements for a guarantor or other covenants. The structure is based on factors including the purpose of the loan, the borrower’s risk profile, and the repayment period. A loan application will only be approved if the loan structure enables the borrowers to achieve the intended purpose, and all of the loan terms are acceptable to both the borrower and lender.
Key Learning Points
- Loan structure refers to the loan term, interest rate, risk, collateral, and repayment.
- Loan structure is designed to meet the borrowers’ financing requirements while protecting the lender from losses due to the borrowers’ failure to repay the debt, interest, and fees.
- Well-structured loans are financially efficient and save time and trouble for both borrowers and lenders. A good loan structure is a win-win with both borrowers and lenders benefitting.
Considerations in Structuring a Loan
Loan structuring focuses on the loan type (fixed or adjustable) and product (conventional, government or jumbo), the amount of loan, the closing costs, the loan term, collateral, guarantees, interest rate, and repayment schedule.
Loan Amount (Principal)
The amount of the loan is the crucial element in the structure, as it must be sufficient to meet the borrower’s needs while reasonable. The right loan product can save the borrower money, as differing products may entail different fees and interest rates.
Loan Term
The term of a loan is the length of time between the loan’s origination and the maturity date. Borrowers need to determine maturity based on whether the funds are to be used for emergencies, one-time situations, or investment in expansion or other long-term business goals.
Interest rate
Interest rates depend on many factors, including the total amount borrowed, the length of the repayment period, the lender, the type of loan, the borrower’s financial profile, and collateral. For example, a borrower with a lower credit rating will be required to pay a higher rate of interest. Understanding loan costs can put borrowers in a stronger position to choose the best option and save on interest and fees.
Repayment
Loan repayment involves setting periodic payments that consist of both principal and interest over the loan’s term. A portion of each payment is used to cover interest charges, while the remainder reduces the loan’s principal balance.
Collateral
Collateral is a tangible asset or collection of assets belonging to the borrower that is pledged as security for the loan. Should the borrower default, the assets become the property of the lender? In structuring term loans, lenders should not only consider the value of the collateral but pay close attention to the historical and expected cash flows from the main source of repayment.
Benefits of Good Loan Structuring
- Loans can be structured in a variety of ways to meet the unique needs of the borrower and the lender. An improperly structured loan can prevent the borrower and lender from achieving the objective of the transaction.
- The right loan structure can provide tax benefits, protect a lender’s assets, and can restructure a lender’s loan when circumstances change more easily.
- With a good loan structure, lenders can recognize and mitigate risks. By effectively identifying and mitigating risks, lenders can price loans to provide acceptable yields while benefiting
Loan Structure Examples
For example, commercial term loans are typically available for up to $600,000, with repayment periods ranging from one to five years and expected interest rates ranging from 7% to 30%. The term loan process is faster and less demanding than traditional bank loans and can be used for a variety of purposes. Therefore, term loans are good options for business owners who want to invest in a specific business segment or have an ongoing working capital need. A loan can finance a real estate purchase, business acquisition, renovation, or expansion.
For business owners who want a flexible form of financing to meet more immediate funding needs in case of cash flow gaps or emergencies, a business line of credit is more suitable. A business line of credit is typically up to $250,000 with an interest rate of 7%-25% and a term of up to 2 years.
Example of Simple Loan Payment Calculation
You are considering applying for a $10,000 loan that will be repaid with equal end-of-month payments over the next 48 months. If the annual interest rate for the loan is 6.5%, how much will your payments be?
Answer: The size of the monthly payment can be determined by inputting values for the three known variables and computing PMT. N = 48; I/Y = 6.5%/12; PV = 10,000; PMT = $237.1
Calculation using excel is shown below:
Access the workout to practice more simple loan payment calculations, and access the full file to check your answer.
Conclusion
Loan structure is generally determined by the purpose of the loan, the repayment ability of the borrower, the cash flow, and the useful life of the assets purchased with the loan. From an investor’s point of view, loan structure is very important. Borrowers should actively structure loans to maximize business profitability. A reasonable loan should benefit both the borrower and the lender.
Explore what you need to know to succeed at credit analysis with our online credit analyst course. The course covers credit analysis for lenders, cash flow modeling, and distressed debt restructuring.