- - AGRICULTURE CORE CURRICULUM - - (CLF1000) Advanced Core Cluster: AGRICULTURAL BUSINESS MANAGEMENT (CLF1400) Unit Title: FINANCE AND CREDIT ____________________________________________________________________________ (CLF1405) Topic: COSTS OF CREDIT Time Year(s) 1 hour 3/4 ____________________________________________________________________________ Topic Objectives: Upon completion of this lesson the student will be able to: Learning Outcome #: (*-*) - Select factors that affect the cost of credit. (*-*) - Understand how interest is calculated. NOTE: Objectives marked *-* are not in the Agriculture Model Currriculum Guide but are considered important components of this unit. Special Materials and Equipment: Supplemental Worksheet #1 and CLF1406 - Glossary References: Luening, R. A., Klemme, R. M., & Mortenson, W. P. (1991). THE FARM MANAGEMENT HANDBOOK (7th ed.). Danville, IL: Interstate Publishers. Osburn D. D., & Schneeberger, K. C. (1983). MODERN AGRICULTURAL MANAGEMENT: A SYSTEMS APPROACH TO FARMING (2nd ed.). Reston, VA: Reston Publishing. Evaluation: Topic Test (attached) TOPIC PRESENTATION: COSTS OF CREDIT A. Costs of Credit 1. The rate of interest is the price paid for borrowing money. a. Interest and principal payments are a fixed cost; they do not vary with the level of production. b. This means that principal and usually interest must be paid regardless of whether the producer has a bumper crop, is hit by drought, or loses the crop entirely. c. Crop insurance helps to manage the risk entailed in borrowing for agricultural enterprises. 2. The interest rate charged by lenders is determined by several factors: a. The rates of interest in the national money markets b. The risk of loss associated with a given loan c. The administration and supervision costs of a loan (the more risky a loan, the higher the costs) d. The amount of competition among lenders e. Legal restrictions on the interest rates that lenders can charge B. How Interest is Calculated 1. The interest rate on a loan is determined by credit supply (the amount of money available, usually on a nationwide basis), demand, risk to the lender, and the cost to make and service the loan. 2. Credit, supply, and demand reflect the national state of the economy and the extent of government involvement in the credit markets. a. The prime rate is the interest rate that major banks charge their biggest and best customers. b. In general, the prime rate reflects the state of the credit markets. The interest rate on most loans is higher than the prime rate. 3. The lender's risk is one factor used to determine how much above the prime rate is charged for a loan. a. The higher the risk, the higher the interest rate. The lender's cost is the cost to make and service the loan. b. Since it costs about the same to make a small loan as it does to make a large loan, the cost to the borrower per dollar loaned is proportionately higher on small loans than it is on large loans. C. Interest 1. There are several ways to calculate interest on a loan: a. Simple interest method b. Unpaid-balance method c. Discount method d. Annual equivalent method 2. With simple interest, the cost of the loan is proportional to the interest rate. The formula for determining simple interest is: a. Interest Rate X Loan Amount X Term = Interest Charge For example, borrowing $1,000 at 10% interest for one year costs $100. The formula is: 0.10 X $1,000 X 1 year = $100/year c. Borrowing $1,000 at 10% interest for six months costs $50. The formula is: 0.10 X $1,000 X 6/12 year = 50/6 months 3. Using the unpaid balance method, interest is charged on only the unpaid balance of the loan. (This is the method used to finance most homes.) a. The payment amount in each period is the same. But with each payment, the amount that goes toward interest decreases and the amount that is applied to the principal increases. b. Table 1 shows the effect on principal and interest charges with the unpaid balance method repayment scheme. The example given is a $10,000 loan for 5 years at 10% interest. ______________________________________________________________________________ TABLE 1 Year Pqyment Principal Interest Balance ---- ------- --------- -------- -------- $10,000 1 $2,638 $1,638 $1,000 8,362 2 2,638 1,802 836 6,560 3 2,638 1,982 656 4,578 4 2,638 2,180 458 2,398 5 2,638 2,398 240 0 ----- ----- --- ----- $13,190 $10,000 $3,190 ______________________________________________________________________________ c. With the simple interest method, an equal amount is paid toward the principal each year for five years. Interest is also paid on the total amount loaned. d. In that case, the interest charge on the same loan would be $5,000 (10 X $10,000 X 5 years) which is an increase of $1,810 for the total cost of the loan over the unpaid balance method. 4. Discount Method of Calculating Interest a. The interest cost is deducted from the loan at the beginning of the term, making the rate of interest paid higher than it appears. b. The formula for this method--which works for a loan that is repaid in one payment--is: 1) Interest charge/actual loan X 100 = interest rate. For example, the interest rate on $1,000 borrowed for one year at 10% would be 100/900 X 100 = 11.1%. c. The reason the interest rate is higher is that the borrower is in reality borrowing only $900 of the $1,000 that is paid back. 1) That is, the borrower actually has the use of $900 (not $1,000) for the year. d. This collecting of interest at the beginning of a loan is a way for the lender to obtain a partial return on the investment immediately. 5. Equivalent Method of Calculating Interest a. The equivalent method is a variation on the discount method of calculating interest. It gives the annual equivalent rate of interest and is used when there are a number of installments to be made over the life of a loan. b. The formula for this kind of loan gives the actual interest rate paid since it takes service charges into account. The formula for finding this "true" interest rate is: 1. (Total charges/half the loan amount) X (number of payments/number of years) X (1/number of payments) = annual interest rate. a. For example, consider a loan of $2,000 borrowed for two years with semiannual payments. The lender charges $600 in interest and carrying charges. ($600/$1,000) X (4/2) X (1/4) = .30 (30% interest) b. What at first may have seemed like a reasonable finance charge is in reality a 30% interest rate. C. When taking out a loan, it is important to find out what interest rate is actually being paid and the total amount the loan will cost. Then compare that rate with the rates other lenders are offering. __________________________________________________________ ACTIVITY: 1. Discuss with the class the effect different interest rates have on loans. Include the effects of inflation in the discussion. 2. Talk about truth-in-lending laws or invite a guest speaker to do so. __________________________________________________________ Supplemental Worksheet #1 Name____________________ Date____________________ - - Interest - - 1. Using the simple interest method, calculate the cost of borrowing $900 at 14% interest for 9 months and also for 16 months. 2. Consider a $2,500 loan for one year at 12% interest. An interest charge of $300 is deducted from the loan when it is received. What is the actual interest rate being paid? (The loan will be paid in full at the end of the year.) 3. Consider a $5,000 loan for three years with monthly payments. The lender charges $1,200 in interest and carrying charges. What is the true interest rate? 4. Determine the difference between the interest rate stated on a loan and the actual rate paid. When is the lender obligated to disclose the true rate? Topic Test Name____________________ Date____________________ - - Interest - - 1. The prime rate is what most borrowers usually pay to borrow money. True or False? 2. The loan costs per dollar of the loan amount are the same for a large loan as for small loan. True of False? 3. Four ways to calculate interest on a loan are _________________________, _____________________, _____________________ and ____________________. 4. When a borrower takes out a loan at 10% interest, this is ALWAYS the actual interest rate being paid. True or False? 5. Paying interest on the unpaid balance is not always cheaper than paying interest on the entire amount borrowed when repaying an installment plan. True or False? 6. Calculate the simple interest charged for borrowing $8,000 for three years at 13%. How much will have been paid at the end of the three-year period? SUPPLEMENTAL WORKSHEET ANSWERS 1. $52.50, $93.33 2. 13.6% 3. 16% 4. Answers will vary. It is preferaable to assign this following the activity discussion. TEST ANSWERS 1. False 2. False 3. Simple, unpaid-balance, discount, annual equivalent method 4. False 5. False 6. $3,120 interest; $11,120 total payments in three years 12/12/91 GFV/EEZ/sg #%&C