Posted : 23 Jul, 2014 00:00:00

http://www.thefinancialexpress-bd.com/2014/07/23/46829


Why bank loans are enigma to borrowers

M. S. Siddiqui

The word 'mortgage' has been derived from a French legal term used by English lawyers in the
Middle Ages meaning "death pledge", and refers to the pledge ending (dying) when either the
obligation is fulfilled or the property is taken through foreclosure.

A mortgage loan, also referred to as a mortgage, is used for securing loan from financial
institutions to buy property, and use the property as mortgage. The loan is secured on the
borrower's property. A mortgage occurs when an owner pledges his or her interest, i.e., right to
the property as security or collateral for a loan.

This means that a legal mechanism is put in place which allows the lender to take possession of
and sell the secured property ('foreclosure' or 'repossession') to pay off the loan in the event the
borrower defaults on the loan or, otherwise, fails to abide by its terms.

Bankers provide funds against property to earn interest income, and generally borrow these funds
themselves by taking deposits. Banks take deposits and use those to offer simple interest rate to
the depositors, but charge compound interest on extended loans. Compound interest is on the
loan and the interest on interest accrued on certain intervals. Bank interest rate is crucial for both
banks and borrowers for any loan.

Bankers in Bangladesh apparently exercise many hide-and-seek methods with interest rate, loan
processing fees, collection fees and also loan account closing charges etc. Bankers have
obligation to disclose certain information to the borrowers, in simple and understandable terms,
before signing a loan agreement. A borrower must know the estimated total amount of interest to
be paid on the loan, the aggregate amount paid by the borrower on the loan, with separate
identification of the amount the borrower has paid in interest on the loan, the amount of fees the
borrower has paid on the loan, and the amount paid against the balance in principal.

Banks have many methods to calculate interest rates having different names and it is a difficult
subject for the borrowers. Each method changes the amount of interest for the same amount of
loan. Banks also apply many methods of calculating interests. Those include Term Mortgage
loan, Constant Amortisation Mortgage (CAM) loan, Negative Amortisation, Fixed-Rate
Mortgage (FRM) etc.

Amortisation means a payment system which reduces outstanding loans over time. A 'negative
amortisation loan' means payment of an amount lower than accrued interests -- the outstanding
interest added to the loan amount over time. The loan payment is figured by using the loan
amount, the interest rate, and the number of years to pay back the loan. It ultimately generates
interests on accrued interests.

For a traditional mortgage, a borrower pays enough each month to cover some interests and some
principal. One such loan is Constant Amortisation Mortgage (CAM) loan. CAMs were popular
among the Western bankers in the period following the Great Depression after the 2nd World
War. Prior to that, term mortgage loans were common vehicles for financing real estate
purchases.

Term Loans are periodic interest payments, but with no amortisation of principal until the end of
the specified term (typically 5-7 years), in which time a ballooned payment for the entire
principal balance becomes due. A 'ballooned payment' is required at the end of the term to repay
the remaining principal balance of the loan. These loans fell out of favour with lenders, as the
Depression left borrowers unable to pay required principal when loans matured and, thereby,
brought about foreclosures.

CAMs then became popular with borrowers for their relatively long payment schedules, and with
lenders for their rapid amortisations. CAMs have now generally been replaced by level-payment
fixed-rate mortgages (FRMs).

The CAM structure, with its high early-year payments, does impose a tilt problem on the
borrowers. Tilt effect occurs when current payments reflect future expected inflation. Current
FRM payments reflect future expected inflation rates. Mortgage payment becomes a greater
portion of the borrowers' income and may become burdensome as bankers are used to calculating
interests on the basis of future inflation. The Graduated Payment Mortgage (GPM) loan, with its
low initial payments, helps in reducing the tilt problem observed with FRMs. In fixed-rate
mortgages the payment increases gradually from an initial low-base level to a desired, final level.
Typically, the payments will grow 7-12 per cent annually from their initial base payment amount
until the full payment is reached. This type of mortgage payment system may be optimal for
young homeowners as their income levels gradually rise to meet higher mortgage payments.

The main reason the negative amortisation loans exists is lower monthly payments. Some people
use loans with negative amortisation to move into a house they otherwise cannot afford. Usually
they believe that they'll have more income in the future. While you enjoy lower payments today,
a negative amortisation loan will require you to pay more afterwards. Sometimes, this can make
sense. However, use the strategy at your own risk. Speculators may use negative amortisation
loans, when they believe home prices will increase rapidly. Again, it's just a strategy to keep
monthly payments lower. While this may work wonderfully in theory, you should know that
speculating on real estate is risky - and using a negative amortisation loan adds to risk and
leverage.

Banks in the West have developed 'amortisation' process to determine the periodic payment
amount due on a loan. The amortisation repayment model factors varying amounts of both
interest and principal into every instalment, though the total amount of each payment is the same.
This is commonly referred to as self-amortisation in the USA, and as a repayment mortgage in
the UK. Western bankers are very transparent in their activities in their own countries; but they
also follow the same 'procedures' as Bangladeshi banks and keep the borrowers in dark as to how
they calculate the interest and re-payment terms. Borrowers have the right to know about the size
of the loan, maturity of the loan, interest rate, the method of paying off the loan, and other facts.

The bankers should provide a borrower, who has notified the lender that he or she is having
difficulty making payments, with (i) The description of the repayment plans available to the
borrower, and how the borrower may request a change in repayment plan; (ii) A description of
the requirements for obtaining forbearance on the loan and any costs associated with
forbearance; and (iii) A description of the options available to the borrower to avoid default and
any fees or costs associated with these options.

Recent Financial Services Authority guidelines to the UK lenders regarding interest-only
mortgages have tightened the criteria on new lending on an interest-only basis. Moving forward,
the Financial Services Authority (FSA) under the Mortgage Market Review (MMR) has stated
there must be strict criteria on the repayment vehicle being used. As such, the likes of nationwide
and other lenders have pulled out of the interest-only market.

A study issued by the UN Economic Commission for Europe compared German, US, and Danish
mortgage systems. The German Bausparkassen has reported nominal interest rates of
approximately 6.0 per cent per annum in the last 40 years (as of 2004). In addition, they charge
administration and service fees (about 1.5 per cent of the loan amount). However, in the United
States, the average interest rates for fixed-rate mortgages in the housing market started in the
'tens and twenties' in the 1980s and have (as of 2004) reached about 6.0 per cent per annum.

Bangladesh Bank is the regulatory authority for the banks in our country. The banks opt for
charging high interest rates and charge on their own. Recently banks have started using
amortisation to calculate interests (no less than 15 per cent) and prepare schedules of payment
with interests and small amounts of capital but they do not disclose the method transparently to
the borrowers. Borrowers have no opinion on interest rates and the payment schedule. With this
method in place, a borrower is paying advance interests before accrual without any transparent
agreement.

The writer is a Legal Economist.

shah@banglachemical.com