UNIT TWO

IDENTIFY AND DISCUSS THE RANGE OF CREDIT OPTIONS

This unit will also assist you to customer attain the stated objective. Specifically, upon completion of this
learning guide line, you will be able to:

 Compare the types of credit facilities used by business and individual

 Discuss the differences between unsecured and secured loans
 Explain implications of default on secured loans

2.1 Comparing Types of credit facilities used by business and individual

2.1.1 Credit Facilities

A credit facility is a type of financing businesses use to finance ongoing capital needs. Credit facilities can
be revolving, allowing businesses to draw from a line of credit on an as-needed basis, or a conventional
term loan.

Credit facilities can be revolving, allowing businesses to draw from a line of credit on an as-needed basis,
or a conventional term loan. Credit facilities are one of the most common and mainstream financing
solutions for businesses, so it can be worthwhile to understand how they work and their requirements.
Alternative financial products are included as well.

A credit facility is a funding solution that businesses can use to finance various expenses during a
predetermined term. Credit facilities can be revolving, which means the borrower can withdraw some or all
of a predetermined amount until the end of the term. Credit facilities can function as conventional term
loans as well.

2.1.2 Types of Credit facility

There are three main types of credit: installment credit, revolving credit, and open credit. Each of these is
borrowed and repaid with a different structure.

A. Installment credit: Installment credit is a type of loan in which you borrow one lump sum and repay it
with interest in regular fixed payments, or installments, over a certain amount of time. Once an
installment credit loan is paid off in its entirety, the account is considered closed. Examples of
installment credit accounts include mortgages, auto loans, personal loans, and student loans.

 Installment debt, or term debt, is a loan you take out and pay back using a payment schedule. Each
payment you make goes toward the original loan plus interest. There might be additional charges, like a
setup fee and processing fees.

With each payment you make, the balance decreases. After using the loan amount, you cannot continue to
borrow more money, which is different than revolving debt.

There is a set length of the loan. Your lender tells you when the loan term ends. Installment debt is
predictable because your month-to-month payment liability typically does not change.
B. Revolving credit: Revolving credit accounts allow you to repeatedly borrow and repay amounts from a
single line of credit up to a maximum limit. You’re in control over how much you borrow (and
ultimately need to pay back). Interest is charged on any balance remaining after each statement’s due
date, so it’s possible to avoid ever paying interest if you pay your balance in full each month.

As long as you make all your payments on time, the account will remain open indefinitely until you
choose to close it. Credit cards are the most common type of revolving credit, but HELOC (home
equity line of credit) is another example.

C. Open credit: Open credit is unique in that monthly payments vary, and balances are due in full at the
end of each billing cycle. Your electricity bill is a great example of open credit; the amount due
depends on how much electricity you used that month. You’re expected to pay the entire bill within a
certain number of days after receiving it. Many utility bills — such as gas, electricity, water, cable, and
cell service – are considered open credit accounts.

Consumer credit facilities:

Fixed: The types of credit facility that personal for real interest rate by considering time value of money

Personal Loans
Many consumers option for a personal loan at some stage, whether it's to cover the likes of a new car, a
wedding or a family getaway, or to consolidate debt into a single payment. However, it's essential that
anyone thinking about taking out a loan is well informed. There are many loans on the market designed for
various purposes and people in different circumstances, and understanding how they work is the first step in
borrowing responsibility.

A loan is a financial contract in which one party – the lender – agrees to give another party – the borrower –
a specific amount of money, to be paid back monthly over a set period of time. There will also be interest
payments at an agreed rate, and sometimes additional charges for the administration of the loan. The terms
and conditions of a loan will vary from lender to lender, but will be specified in the contract. The borrower
must adhere to the repayment terms stated in the contract – especially repayment dates and interest rates.

Loans come in all shapes and sizes, but, overall, there are two main types: secured and unsecured loans.

Example:

A business receive loan Birr 200,000 from Oromia saving and credit association at 10% annual interest rate
for 2 years and the principal amount will be paid Semi- annually at equal installment.

Amount of principal and interest repayment for the first term

 Loan Amount (Principal): Birr 200,000
 Annual Interest Rate: 10%
 Loan Term: 2 years
 Payment Frequency: Semi-annually
Step 1: Calculate Semi-annual Interest Rate:
The annual interest rate is 10%. To find the semi-annual interest rate, divide the annual rate by the number
of compounding periods per year.
Semi-annual interest rate = Annual interest rate / Number of compounding periods per year Semi-annual
interest rate = 10% / 2 = 5%

Step 2: Calculate Total Number of Payments:

Since the loan term is 2 years with semi-annual payments, there will be a total of 4 payments (2 years * 2
payments per year).

Step 3: Calculate Equal Installment Amount:

To calculate the equal installment amount, we can use the formula for an amortizing loan:

PMT = P (r (1+r)^n)
(1+r)^n -1
Where:
PMT = Equal Monthly Installment payment
P = Loan Amount (Principal)
r = Semi-annual interest rate
n = Total number of payments
Substitute the values into the formula:

PMT = Birr 200,000 × 0.05× (1+0.05)4

(1+0.05)4 – 1
Calculating this will give us the equal installment amount.

Step 4: Breakdown of Principal and Interest Repayment for the First Term:

For the first term, we need to calculate how much of the installment goes towards repaying the principal and
how much goes towards paying off the interest. This can be done using an amortization schedule or loan
repayment calculator.

The principal repayment for the first term will reduce the outstanding balance, and the interest will be
calculated on this reduced balance for subsequent terms.

Loan Payment Schedule Loan Term (year) 2

Loan Amount 200,000 Frequency in a year Semi annually
Interest rate 5% = 0.05 Number of period in year 2
Total No. of period (nper) 4
Periodic Payment/ installment $56,402.37
Amount
Period Payment Interest Principal Ending Balance Recovery
1 56,402 10,000 46,402 153,598 $46,402.37
2 56,402 7,680 48,722 104,875 $95,124.85
3 56,402 5,244 51,159 53,717 $146,283.46
4 56,402 2,686 53,717 0 $200,000.00
Answer:
1) Principal Repayment for the First Term:
Principal Repayment = PMT − Interest Payment

2) Interest Payment for the First Term:

Interest Payment = Outstanding Balance * Semi−annual Interest Rate
 By calculating these values based on the given information and formulas provided above, you can
determine the specific amounts for principal and interest repayment for the first term.

3) Amount of outstanding principal balance of at the end of the first term

Outstanding Principal = Loan received – Loan repayment

Example of personal loan

Mr. X wants to establish a business enterprise with an initial capital of birr 100,000. The investor has
60,000 birr deposit and borrows the remaining amount from Awash bank with an interest rate of 10% that
will be repaid after a year.

Calculates the cash and interest to be collected after a year

Example Two:

The accounting records of XYZ shows the following accounts as of January 1, 2012.
Prepaid rent 40,000
Supplies, 6,000
Prepaid insurance, 2,000
Equipment 80,000
Building 70,000
Account payable 12,000
Note payable 9,000
Assume that the company wants to introduce a new product with the required capital of Birr 360,000. The
company applied for credit at Addis international bank Share Company in order to finance the required
capital. The bank accepted application and agreed with 12% interest semiannually with equal installment
semi-annually for five years. The bank charged birr 2,500 for facilitating the loan. The company estimates a
profit of Br 90,000.

A. Calculates the amount of borrowing financed by Addis international bank?

B. Determine the total expense related to the credit?
C. Record the amount of borrowed on the book of the company?
D. Record the final disbursement of principal and interest on the books of the company?
E. Calculates the estimated rate of return?

Answer:
Task A. from the above mentioned data we can calculate assets and liability of DH PLC.
Asset = Prepaid rent + supplies + prepaid insurance + equipment +Building
Asset = 30,000 + 6,000 + 2,000 + 80,000 + 70,000
Asset = Birr 198,000
Liability = Account payable + Note payable
Liability = 12,000 + 9,000 = 21,000 birr

From simple accounting equation Asset = Liability + Capital

We can find the amount of capital then the formula of capital as follow
Capital = Total Asset – Total Liability
= 198,000 – 21,000
= Birr 177,000

So the amount of Borrowing Financed by Awash Bank = 360,000 – 177,000 = 203,000 Birr

Task 2.2. Required total expense related to the credit

Borrowed amount = 203,000 birr

Interest rate = 12%
Year = 5 years
Semi-annually = 5 x 2 = 10
Service charge = 2,500

A revolving loan facility is a line of credit often extended to businesses that a borrower can draw from and
pay back multiple times. It differs from a term loan in that it comes with a maximum credit amount, and
borrowers can repeatedly withdraw money and repay the loan.

A revolving loan facility is a line of credit often extended to businesses that a borrower can draw from and
pay back multiple times. It differs from a term loan in that it comes with a maximum credit amount, and
borrowers can repeatedly withdraw money and repay the loan.

This flexible form of financing allows borrowers to access funds as needed. That makes a revolving loan
facility a good option for businesses that have ongoing working capital needs. Learn more about how
revolving loan facilities.

A revolving loan facility is a variable line of credit generally used by businesses. It’s a flexible form of
credit that allows borrowers to withdraw funds on an as-needed basis. A revolving loan facility may have
multiple terms and limits within its lifespan, and may cap the number of outstanding balances you have at
any one time. Because of this, a revolving loan facility may come with higher interest rates than what you’d
receive on a fixed-rate loan.

A revolving loan facility is a popular option for businesses because it can help with cash flow problems.
The company will often draw funds to cover a working capital need. It’s beneficial during times of the year
when businesses experience inconsistent revenue.

For example, a business might use a revolving loan facility to cover payroll or other operating expenses
during a slow season. When the company receives payment from its client or customers, it can repay the
loan.
Types of Revolving Credit

The term revolving credit refers to a type of account that allows a customer to borrow and repay money on
a repeated basis. The most common examples of revolving credit are as follows.

A. Credit cards: Is perhaps the most recognizable form of revolving credit. Both consumers and
businesses may qualify for credit card accounts. In general, better credit scores lead to better interest
rates and borrowing terms.
B. Business line of credit is a type of revolving credit that’s available for business purposes. This
borrowing option can be secured or unsecured, with varying credit limits, loan terms, and interest rates
based on the creditworthiness of the business and other factors.
C. Commercial building equity line of credit is a type of financing where the borrower receives a line of
credit based on the amount of equity that’s available in their commercial property. The property serves
as collateral.
D. Home equity line of credit or HELOC is another type of revolving credit in which a borrower’s
property serves as collateral to secure the account. However, in this scenario the borrower is an
individual consumer, not a business.

Reason of Revolving Line Of Credit

There are numerous reasons your business may want to consider opening a revolving line of credit.
 Access to a flexible source of funding.
 Working capital on a periodic or seasonal basis.
 A non-specific amount of funding for an upcoming project or investment.
 The ability to borrow money quickly in an emergency.
 A way to build better business credit history and credit scores for the future

Figure 2.1: Revolving Credit Facilities

The lender may calculate your interest based on a whole year and display it as a percentage. From there, the
revolving line of credit interest formula is the principal balance multiplied by the interest rate, multiplied by
the number of days in a given month. This number is then divided by 365 to determine the interest you’ll
pay on your revolving line of credit.

Revolving Line of Credit Interest Formula

(Principal Balance X Interest Rate X Days in Month) / 365

 Revolving credit Vs installment credit

 To make smaller purchases on short notice, it’s best to use revolving credit. For large expenses,
installment debt is the better option.
 Interest rates are higher for revolving debt than installment debt.
 Try to pay off revolving debt quickly and stay away from accumulating too much debt.

Table 2.1: Difference between installment debt and revolving debt

2.1.2 Types of Credit Facilities

A. Short term credit facilities

Short term credit facilities are designed to only last for a while, and can be further divided into the
following:

Cash credit and overdraft: This type of short term credit facility allows you to withdraw more than the
fund present in your deposit account. However, you would also pay interest on the amount you overdrew.

Trade finance: Trade finance is a type of short term credit facility that is generally essential to the efficient
cash flow of a company. It could come in different forms including supplier’s credit, export credit, letters of
credit, and factoring.

B. Long term fixed credit facilities

They design long-term credit facilities to appeal to corporations looking at obtaining long-term loans. The
different types include:

Bank loans: This is a very common long term credit facility that comes with a definite tenor and repayment
schedule. Also, banks thoroughly access lenders before giving out a loan to address their credit risk. The
lower the better, and a higher chance of you getting loan approval from the bank. You can read more on
how you can get a bank loan.
Notes: This is an unsecured credit facility that is mostly raised from private or capital market. Therefore, it
is usually only considered when banks are not willing or have reached their lending limit.

2.1.3 Credit Facility Work

Credit facilities can operate as a revolving line of credit—the business that gets the line of credit withdraws
up to a certain limit when the situation demands it—but this is not always the case. A credit facility can also
function as a term loan, where the funds are disbursed in a single advance, and amounts repaid can’t be re
borrowed.

2.2 Discussing the differences between unsecured and secured loans

2.2.1 Secured loans

A secured loan, you need collateral. Just as a house is held as collateral in the case of a mortgage loan and
auto for an auto loan, you need some type of collateral for a secured personal loan.

Your collateral might be money in a traditional savings or credit union share account, share certificate or
CD. If you are approved for a secured loan, a lender will put a lien on an asset until the loan is paid off.
Secured personal loans typically have lower interest rates than unsecured loans. Makes sense, right? A
lender is taking a bigger risk with an unsecured personal loan, so it seems logical that the interest rate would
be a bit higher on a riskier loan. As with any type of loan, your credit score and payment history also come
into play when qualifying for a lower interest rate.

Secured personal loans may have a higher borrowing limit or longer repayment terms than unsecured
personal loans. Again, this is dependent on the lender and also the collateral used for the loan.

Secured debts are tied to an asset that's considered collateral for the loan. Lenders place a lien on the asset,
giving them the right to take the asset if you fall behind on your payments

2.2.2 Unsecured loans

Unsecured loans attract higher interest rates due to increased risk to the lending institution

With unsecured loans, lenders don't have rights to any collateral for the loan. If you fall behind on your
payments, they don't have the right to take any of your assets. However, the lender may take other actions to
get you to pay.

For example, they will hire a loan collector to coax you to pay the loan. If that doesn't work, the lender
may sue you and ask the court to garnish your wages, take an asset, or put a lien on another your assets until
you've paid your loan. They'll also report the delinquent status to the credit bureaus so it can be reflected on
your credit report.

Credit card loan is the most widely-held unsecured loan.

Other unsecured loans include student loans, payday loans, medical bills, and court-ordered child support.
Unsecured loans attract higher interest rates due to increased risk to the lending institution

2.3 Implications of default on secured loans

Breaching a loan contract comes with consequences. Defaulting sends a red flag to other financial entities
that you are not a reliable borrower, and may not be trustworthy in other aspects as well.
Some lenders report delinquencies if you're late on a bill. For the first 30 days after a payment is due, you’re
probably in the clear, but missed payments that lead to default will be reported to credit bureaus, resulting
in lower credit scores.

A. Low credit scores can impact several areas of your life. You might have a harder time renting, finding
a job, signing up for utilities and mobile phone service, and buying insurance.

B. Increased Costs
Defaulting can also increase your debt. Late payment fees, penalties, and legal costs might .

In fact, considering the effects of compound interest, outstanding debt grows quickly. When you miss
payments, your monthly interest charges are added to the principal balance of the loan; future interest is
then charged on this greater balance, which can quickly snowball.

Certain events, conditions, or circumstances may be considered a breach of contract and, therefore,
an event of debt default.

Events of default include, but are not limited to:

 Non-payment or late payment of interest and/or principal

 Covenant breaches
 Changes in ownership or control