LECTURE NOTES ON AGRICULTURAL FINANCE AND CREDIT

LECTURE ONE

Meaning and Scope

Meaning:
Agricultural finance generally means studying, examining and analyzing the financial aspects
pertaining to farm business, which is the core sector of India. The financial aspects include money
matters relating to production of agricultural products and their disposal.
Definition of Agricultural finance:
Murray (1953) defined agricultural. Finance as “an economic study of borrowing funds by farmers,
the organization and operation of farm lending agencies and of society’s interest in credit for
agriculture.”
Tandon and Dhondyal (1962) defined agricultural Finance “as a branch of agricultural economics,
which deals with and financial resources related to individual farm units.”
Concepts of Agricultural Finance
“Agricultural Finance”, according to Tandon and Dhondeyal (1991), could be considered as a
branch of Agricultural Economics that deals with the provision and management of Bank services
and financial resources related to individual farm units.
“Agricultural Finance” deals with the financial,(micro and macro aspects of a farm business in an
economy.
“Agricultural Finance” is the economic study of the acquisition and use of capital in agriculture. So
it deals with the demand for, and supply of funds in the agricultural sector of the economy (W.F Lee,
1980)
“Agricultural Finance” is the study of financing and liquidity services as well as credit provision to
farm Borrowers.
“Agricultural Finance” is the study of financial intermediaries who provide loanable funds for
agricultural production and that of financial markets in which these intermediaries obtain their
loanable funds (Penson and Lins, 1990).
The study could be broadened to mean the analysis of financial structure of Agriculture and the
wealth position of farm owners.
Broadened further, “Agricultural Finance” involves the study of all economic and financial
interface between agriculture and the rest of the macro economy ; including the effects that changes
in the national economic policies could have on the economic performance of agriculture as well as
the financial positions of individual farm families.

Nature and Scope:

Agricultural finance can be dealt at both micro level and macro level. Macrofinance deals with
different sources of raising funds for agriculture as a whole in the economy. It is also concerned with
the lending procedure, rules, regulations, monitoring and controlling of different agricultural credit
institutions. Hence macro-finance is related to financing of agriculture at aggregate level.
Micro-finance refers to financial management of the individual farm business units. And it is
concerned with the study as to how the individual farmer considers various sources of credit,

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quantum of credit to be borrowed from each source and how he allocates the same among the
alternative uses within the farm. It is also concerned with the future use of funds.
Therefore, macro-finance deals with the aspects relating to total credit needs of the agricultural
sector, the terms and conditions under which the credit is available and the method of use of total
credit for the development of agriculture, while micro-finance refers to the financial management of
individual farm business.
Significance of Agricultural Finance:
1) Agric finance assumes vital and significant importance in the agro – socio – economic
development of the country both at macro and micro level.
2) It is playing a catalytic role in strengthening the farm business and augmenting the productivity of
scarce resources. When newly developed potential seeds are combined with purchased inputs like
fertilizers & plant protection chemicals in appropriate / requisite proportions will result in higher
productivity.
3) Use of new technological inputs purchased through farm finance helps to increase the agricultural
productivity.
4) Accretion to in farm assets and farm supporting infrastructure provided by large scale financial
investment activities results in increased farm income levels leading to increased standard of living
of rural masses.
5) Farm finance can also reduce the regional economic imbalances and is equally good at reducing
the inter–farm asset and wealth variations.
6) Farm finance is like a lever with both forward and backward linkages to the economic
development at micro and macro level.
7) As Cameroonian agriculture is still traditional and subsistence in nature, agricultural finance is
needed to create the supporting infrastructure for adoption of new technology.
8) Massive investment is needed to carry out major and minor irrigation projects, rural
electrification, installation of fertilizer and pesticide plants, execution of agricultural promotional
programmes and poverty alleviation programmes in the country.

Needs and the Roles of Credit in Agricultural Development.

Basic Concepts of “Agricultural Credit”
The word “Credit” is derived from a Latin word “Credo”, meaning “I Believe”. The Latin verb
“credere” means “to repose confidence in”. Note that borrowing is a function of ability to
command capital or services currently with a promise to repay it in future i.e obtaining certain
amounts of money as loan to be rapid as specified in the Agreement between the concerned parties.
This is often based on confidence in the borrowers’ future solvency and repayment.
Credit means the ability to command other peoples’ capital in return for a promise to repay at some
specified time in future. It is therefore the combination of the “ability to borrow” and “willingness to
borrow”. It can also be regarded as an economic good to be produced, managed and marketed.
Credit also means the control over money, materials, goods or services in the present in exchange
for a promise to repay at some future dates. This implies that, lenders forgo the use of money or its
equivalent in the current time by making loans available or extending the credit to the borrower who
promises to repay on terms specified in the loans Agreement or debt Instruments. Borrowers obtain
resources to use for current production/consumption purposes before generating savings that could
be used to repay the goods.

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Credit is an advance of money or its equivalent given by a Lender to a Borrower for repayment at
maturity, which may range from a few days to several years.
Credit is the monetary financial aspect of capital resources which is generally considered as goods
employed but not used up in the course of production. Credit in this case could take the forms of
biological or physical capital purchased and supplied to the producer
Credit is the acquisition and control over funds at a cost for specific period at the end of which the
control ceases and the funds revert back to the creditors.
Agricultural Credit is the temporary inputs transferred to a willing borrower for agricultural
purpose, with the borrower’s potential willingness and promise to repay in a particular for after use
and the confidence by the Lender that the Borrower will comply with terms, utilization and
repayment with, or without monitoring.
Agricultural Credit is the capital or money rented by a farmer in the present,(with a specific interest
rate charge and future repayment period), from a Lender in a credit institution, for agricultural
production and marketing activities.
Credit is a combination of “potentiality” (with a promise to repay money) and “actuality” (obtaining
goods and services). It is the present right to future payment or power of borrower, where the
Borrower has the power to borrow and lender the right to execute actions against the Borrower.
Credit involves the element of obligations for the Borrower to make a return and confidence by the
lender on the Borrower’s faith and ability to repay.
Credit is a device for facilitating temporary transfer of purchasing power from an
individual/Organization to another.
Credit is the overall arrangement through which inputs,(cash) and kind), are made available to
farmers who repay such inputs as stated in the repayment schedule with due interest.
Agricultural Credit encompasses all loans and advances granted to a borrower to finance activities
relating to agriculture, fisheries, forestry and for processing and distribution of products resulting
from these activities.
The Continued Needs for Credit for Agricultural Development
Agricultural Credit is an important instrument for channeling funds from Savers to borrowers in
amount necessary to finance production expenses and capital expenditures. With the limited
subsidies on inputs in the 1990s and the increasing costs of the inputs required to carry out farming
operations, there is always need by farmers for credit to be able carry out the operations, purchase
the inputs and fulfill his domestic obligations. Farmers need credit to expand their scales of
operations and improve on the levels of technology, as accessibility has implications for technology
adoption. For the agricultural sector to perform creditably well, credit is essential for the
achievements of sound economic and social development, which the nation requires. In developing
countries, Farmers are poor-resource. They therefore need money to purchase their requirements and
increase productivity in growth and output. This could be achieved through credit supply. Suitable
credit delivery and collection system can be used to facilitate the procurement of production needs of
farmers Credit is needed to break the persistent vicious cycle of poverty among farmers. Farmers
need credit to practice commercial production.
The Roles of Credit for Agricultural Development Adoption of modern technologies require
capital. Farmers’ incomes are seasonal while his working expenses are usually spread over time.
However, farmers’ inadequate savings require that some credit be harnessed to meet the increasing
capital requirements.

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Credit is a unique resource that provides the opportunity to use additional inputs and capital items in
the present to pay for them from future earnings.

Credit has both static and dynamic characteristics. In its dynamic nature, when farmers adopt
improved agricultural production technologies, institutional credit can be used for increasing
agricultural production and proceeds will be available for both production and consumption rather
than for the payment old debts . Note that, under this situation, it is important that institutional credit
are not only supplied in due time but also adequately. This implies that credit can only play its
dynamic role, only in relation to agricultural production technology and in the presence of credit
absorption capacity.

Credit fills the gap between demand and supply resulting from investments Stimulates agricultural
production especially in the rural areas. Helps production to meet up with current expenses,
Stimulates production and raise the levels of income of farmers.

Given the peculiar problem of agriculture in Cameroon, start-up credit is needed to create effective
demand or ability to pay back.

Credit can induce profitability of current economic activities but also shifts production from
subsistence to commercial and induce employment among those who lack basic necessities to engage
in productive activities.

LECTURE TWO: SOURCES OF AGRICULTURAL FINANCE

Preamble
Sources of finance for agricultural projects are quite many and in this context refer to the lenders,
ranging from the relatives of the Borrowers to Government. The various sources are derived from
two major sources, namely, Institutional/formal sources and non institutional/ informal sources.
Institutional credit sources can further be divided into domestic and foreign sources.
2.1 Sources of Finance
There are two major sources of finance: Institutional/formal and Non-institutional/Informal
2.1.1 Non-Institutional /Informal Sources
* includes relatives, friends, Merchants, money Lenders
* Loans are made directly on personal basis from Lenders to Borrowers, especially where the
individuals are familiar with some level of confidence in one another
*Methods of obtaining the loans are relatively easier and there is a rare tendency for administrative
delays
*Non-insistence on security /collaterals by Lenders
*Flexibility is associated with repayment schedule with high rates of interest
*The flexibility built into the repayment makes this source very popular among peers and famers.
Demerits
*More expensive supply of credit because of high interest rate
*Inadequate credit supply and on terms required by farmers for farm expansion and modernization

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* There are differences in the process of acquiring loans from one source to another e.g. relatives and
friends have no laid down procedures and no repayment arrangements specified. Interest is usually
free.
*Money Lenders charge exorbitant rates of interest, though prompt and timely in disbursement of
funds required.
Tontines/ ‘Njangies’
Management depends on culture under which they have been organized.
Mobile bankers.
Usually organized by self-appointed itinerant; collectors who keep encouraging individuals to save
money. He goes round to collect money according to the financial strength of the participants.
Usually, the first day’s contributions represent the Collectors; charges on banking services rendered
and whatever the Contributor can add during the month will be refunded on the first day of the
following month, if so desired. The savings attract no interest but save time and costs.
Money Lenders
Some of the mobile bankers Collected also perform the roles of money lending, giving out some of
the Contributors’ to Borrowers who would be expected to pay back fully (Principal + Interest) before
the end of the month, when the Contributors will expect some refunds.
2.1.2 Formal/Institutional Sources
Financial Institutions (Domestic)
Essentially “Financial Institutions “refer to:
(i) Bank Financial Institutions (BFIs) and
(ii) Non- Bank Financial Institutions (NBFIs) .
In developing countries’, financial system, there are four categories of Banks which are directly or
indirectly involved and connected to agricultural financing. These are:
(i) Commercial Banks (ii) Merchant Banks
(iii) Development Banks (iv) Specialized banks
Commercial Banks
Dominates the financial intermediation process and are commonly referred to as ‘retail banks” due to
services extended to farmers as individuals rather to corporate entities. The primary role of the
commercial Banks is to intermediate funds between the surplus and the deficit economic units of the
economy, especially at the retail segment of the markets. The Banks are to mobilise savings,
stimulate investments and economic growth through lending operations, assist in resource allocation
and promote domestic and international trades. Therefore, apart from the main lending activities of
commercial banks, provision of short term financing, they also render ancillary services such as
keeping save custody of the customers’ valuable items, acting in trust and execution of capacities for
customers’ will.
Merchant Banks
Commonly referred to as the “wholesale banks”, Merchant banks engage in the intermediation
between the surplus and the deficit sector through wholesale banking to large scale
investors/Corporate bodies and Institutional clients by financing medium and long term credits. They
do this through activities like equipment leasing, loan syndication, debt financing, apart from
rendering assistance as issuing agents and advise on funds sourcing.
Development Banks
Micro-finance Banks

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Micro-finance Banks in Cameroon are self-sustaining financial institutions owned and managed by
local communities to render services to their respective communities. They are meant to promote
agriculture, rural as well as economic growth through development at grassroots level. Though their
activities are geared towards rural banking, they are also noted for accepting deposits, running other
banking services and investing funds in agriculture apart from providing facilities to farmers.
Non-Bank financial Institutions (NBFI)
Commonly called “other financial Institutions and funds”, they intermediate in the wider financial
system. Examples are Insurance companies , finance houses , Discount houses , Bureau de Change,
National Providence Funds etc.
2.2 Other Domestic Sources.
Financial Markets
Represents a forum where surplus funds are channeled into productive use through a process of
financial intermediation. It consists of the money markets for short term funds and capital market for
long term funds. Not necessarily a physical location as we have in the goods market but a mechanism
through which funds are transferred (bought and sold) through the banks (physical location) or
through telecommunication system (non-physical location), using financial instruments. Note that the
process through which funds are channeled from the surplus (depositors) to the deficit
(borrowers/Needs) a unit for a return (interest) is called financial intermediation.

LECTURE THREE: CLASSIFICATION OF CREDITS

Generally, Credit can be classified on the basis of the following:
1. Based on time: This classification is based on the repayment period of the loan. It is sub-divided
in to 3 types:
- Short–term loans: These loans are to be repaid within a period of 6 to 18 months. All crop loans
are said to be short–term loans, but the length of the repayment period varies according to the
duration of crop. The farmers require this type of credit to meet the expenses of the ongoing
agricultural operations on the farm like sowing, fertilizer application, plant protection measures,
payment of wages to casual labourers etc. The borrower is supposed to repay the loan from the sale
proceeds of the crops raised.
- Medium – term loans: Here the repayment period varies from 18 months to 5 years. These loans
are required by the farmers for bringing about some improvements on his farm by way of purchasing
implements, electric motors, milch cattle, sheep and goat, etc. The relatively longer period of
repayment of these loans is due to their partially-liquidating nature.
- Long – term loans: These loans fall due for repayment over a long time ranging from 5 years to
more than 20 years or even more. These loans together with medium terms loans are called
investment loans or term loans. These loans are meant for permanent improvements like leveling and
reclamation of land, construction of farm buildings, purchase of tractors, raising of orchards, etc.
Since these activities require large capital, a longer period is required to repay these loans due to
their non - liquidating nature.

2. Based on Purpose: Based on purpose, credit is sub-divided in to 4 types.

- Production loans: These loans refer to the credit given to the farmers for crop production and are
intended to increase the production of crops. They are also called as seasonal agricultural operations

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(SAO) loans or short – term loans or crop loans. These loans are repayable with in a period ranging
from 6 to 18 months in lumpsum.
- Investment loans: These are loans given for purchase of equipment the productivity of which is
distributed over more than one year. Loans given for tractors, pumpsets, tube wells, etc.
- Marketing loans: These loans are meant to help the farmers in overcoming the distress sales and
to market the produce in a better way. Regulated markets and commercial banks, based on the
warehouse receipt are lending in the form of marketing loans by advancing 75 per cent of the value
of the produce. These loans help the farmers to clear off their debts and dispose the produce at
remunerative prices.
- Consumption loans: Any loan advanced for some purpose other than production is broadly
categorized as consumption loan. These loans seem to be unproductive but indirectly assist in more
productive use of the crop loans i.e. without diverting then to other purposes. Consumption loans are
not very widely advanced and restricted to the areas which are hit by natural calamities. These loams
are extended based on group guarantee basis with a maximum of three members. The loan is to be
repaid within 5 crop seasons or 2.5 years whichever is less. The branch manager is vested with the
discretionary power of sanctioning these loans. The rate of interest is around 11 per cent.
The scheme may be extended to
1) IRDP beneficiaries
2) Small and marginal farmers
3) Landless Agric. Laborers
4) Rural artisans
5) Other people with very small means of livelihood such as carpenters, barbers, washermen, etc.

3. Based on security: The loan transactions between lender and borrower are governed by
confidence and this assumption is confined to private lending to some extent, but the institutional
financial agencies do have their own procedural formalities on credit transactions. Therefore it is
essential to classify the loans under this category into two sub-categories viz., secured and unsecured
loans.
- Secured loans: Loans advanced against some security by the borrower are termed as secured
loans. Various forms of securities are offered in obtaining the loans and they are of following types.
I. Personal security: Under this, borrower himself stands as the guarantor. Loan is advanced on the
farmer’s promissory note. Third party guarantee may or may not be insisted upon (i.e. based on the
understanding between the lender and the borrower)
II. Collateral Security: Here the property is pledged to secure a loan. The movable properties of the
individuals like LIC bonds, fixed deposit bonds, warehouse receipts, machinery, livestock etc, are
offered as security.
III. Chattel loans: Here credit is obtained from pawn-brokers by pledging movable properties such
as jewellery, utensils made of various metals, etc.
IV. Mortgage: As against to collateral security, immovable properties are presented for security
purpose For example, land, farm buildings, etc. The person who is creating the charge of mortgage is
called mortgagor (borrower) and the person in whose favour it is created is known as the mortgagee
(banker). Mortgages are of two types:
a) Simple mortgage: When the mortgaged property is ancestrally inherited property of borrower
then simple mortgage holds good. Here, the farmer borrower has to register his property in the name

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of the banking institution as a security for the loan he obtains. The registration charges are to be
borne by the borrower.
b) Equitable mortgage: When the mortgaged property is self-acquired property of the borrower,
then equitable mortgage is applicable. In this no such registration is required, because the ownership
rights are clearly specified in the title deeds in the name of farmer-borrower.
V. Hypothecated loans: Borrower has ownership right on his movable and the banker has legal right
to take a possession of property to sale on default (or) a right to sue the owner to bring the property
to sale and for realization of the amount due. The person who creates the charge of hypothecation is
called as hypothecator (borrower) and the person in whose favor it is created is known as
hypothecate (bank) and the property, which is denoted as hypothecated property. This happens in the
case of tractor loans, machinery loans etc. Under such loans the borrower will not have any right to
sell the equipment until the loan is cleared off. The borrower is allowed to use the purchased
machinery or equipment so as to enable him pay the loan installment regularly. Hypothecated loans
again are of two types viz., key loans and open loans.
a) Key loans: The agricultural produce of the farmer - borrower will be kept under the control of
lending institutions and the loan is advanced to the farmer. This helps the farmer from not resorting
to distress sales.
b) Open loans: Here only the physical possession of the purchased machinery rests with the
borrower, but the legal ownership remains with the lending institution till the loan is repaid.
- Unsecured loans: Just based on the confidence between the borrower and lender, the loan
transactions take place. No security is kept against the loan amount

4. Lender’s classification: Credit is also classified on the basis of lender such as

- Institutional credit: Here are loans are advanced by the institutional agencies like co-operatives,
commercial banks. Ex: Co-operative loans and commercial bank loans.
- Non-institutional credit : Here the individual persons will lend the loans Ex: Loans given by
professional and agricultural money lenders, traders, commission agents, relatives, friends, etc.

5. Borrower’s classification: The credit is also classified on the basis of type of borrower. This
classification has equity considerations.
- Based on the business activity like farmers, dairy farmers, poultry farmers, pisiculture farmers,
rural artisans etc.
- Based on size of the farm: agricultural labourers, marginal farmers, small farmers, medium
farmers, large farmers,
- Based on location hill farmers (or) tribal farmers.

6. Based on liquidity: The credit can be classified into two types based on liquidity and they are
- Self-liquidating loans: They generate income immediately and are to be paid within one year or
after the completion of one crop season. Ex: crop loans.
- Partially -liquidating: They will take some time to generate income and can be repaid in 2-5 years
or more, based on the economic activity for which the loan was taken. Ex: Dairy loans, tractor loans,
orchard loans etc.,

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7. Based on approach:
- Individual approach: Loans advanced to individuals for different purposes will fall under this
category
- Area based approach: Loans given to the persons falling under given area for specific purpose will
be categorized under this. Ex: Drought Prone Area Programme (DPAP) loans, etc
- Differential Interest Rate (DIR) approach: Under this approach loans will be given to the weaker
sections @ 4 per cent per annum.

8. Based on contact:
- Direct Loans: Loans extended to the farmers directly are called direct loans. Ex: Crop loans.
- Indirect loans: Loans given to the agro-based firms like fertilizer and pesticide industries, which
are indirectly beneficial to the farmers are called indirect loans.

Lecture four: Credit Analysis-Economic Feasibility

________________________________________________________________________
The technological break-thorough achieved in Indian agriculture made the agriculture capital
intensive. In India most of the farmers are capital starved. The farmers need credit at right time,
through right agency and in adequate quantity to realize maximum productivity. This is from
farmer’s point of view. In contrast to the farmer’s point of view, when a farmer approaches an
Institutional Financial Agency (IFA) with a loan proposal, the banker should be convinced about the
economic viability of the proposed investments.

4.1 Economic Feasibility Tests of Credit

When the economic feasibility of the credit is being observed, three basic financial aspects are to be
assessed by the banker. If the loan is advanced,
1. Will it generate returns more than costs?
2. Will the returns have surplus, to repay the loan when it falls due?
3. Will the farmer stand up to the risk and uncertainty in farming?
These three financial aspects are known as 3 Rs of credit, which are as follows
1. Returns from the proposed investment
2. Repayment capacity the investment generates
3. Risk- bearing ability of the farmer-borrower
The 3Rs of credit are sound indicators of credit worthiness of the farmers.

Returns from the Investment

This is an important measure in credit analysis. The banker needs to have an idea about the extent of
returns likely to be obtained from the proposed investment. The farmer’s request for credit can be
accepted only if he can be able to generate returns that enable him to meet the costs. Returns
obtained by the farmer depend upon the decisions like,
What to grow?
How to grow?
How much to grow?
When to sell?
Where to sell?

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Therefore the main concern here is that the farmers should be able to generate incremental returns
that should cover the additional costs incurred with borrowed funds.

Repayment Capacity
Repayment capacity is nothing but the ability of the farmer to repay the loan obtained for the
productive purpose with in a stipulated time period as fixed by the lending agency.
At times the loan may be productive enough to generate additional income but may not be productive
enough to repay the loan amount. Hence the necessary condition here is that the loan amount should
not only profitable but also have potential for repayment of the loan amount. Under such conditions
only the farmer will get the loan amount. The repayment capacity not only depends on returns, but
also on several other quantitative and qualitative factors as given below.
Y= f(X1, X2, X3, X4 X5, X6, X7…)
Where, Y is the dependent variable ie., the repayment capacity
The independent variables viz., X1to X4 are considered as quantitative factors while X 5 to X7 are
considered as qualitative factors.
X1(+) = Gross returns from the enterprise for which the loan was taken during a season /year
X2(-) = Working expenses.
X3(-) = Family consumption expenditure.
X4(-) = Other loans due.
X5(+) = Literacy
X6(+) = Managerial skill
X7(+) = Moral characters like honesty, integrity etc.
Note: Signs in the brackets are apriori signs.
Hence, eventhough the returns are high, the repayment capacity is less because of other factors. The
estimation of repayment capacity varies from crop loans (i.e. self liquidating loans) to term loans
(partially liquidating loans)
i) Repayment capacity for crop loans
Gross Income- (working expenses excluding the proposed crop loan + family living expenses + other
loans due+ miscellaneous expenditure)
ii) Repayment capacity for term loans
Gross Income- (working expenses + family living expenses + other loans due+ miscellaneous
expenditure + annual installment due for term loan)

Causes for the poor repayment capacity of farmer

1. Small size of the farm holdings due to fragmentation of the land.
2. Low production and productivity of the crops.
3. High family consumption expenditure.
4. Low prices and rapid fluctuations in prices of agricultural commodities.
5. Using credit for unproductive purposes
6. Low farmer’s equity/ net worth.
7. Lack of adoption of improved technology.
8. Poor management of limited farm resources, etc

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Measures for strengthening the repayment capacity
1. Increasing the net income by proper organization and operation of the farm business.
2. Adopting the potential technology for increasing the production and reducing the expenses on the
farm.
3. Removing the imbalances in the resource availability.
4. Making the schedule of loan repayment plan as per the flow of income.
5. Improving the networth of the farm households.
6. Diversification of the farm enterprises.
7. Adoption of risk management strategies like insurance of crops, animals and machinery and
hedging to control price variations ,etc.,

Risk Bearing Ability

It is the ability of the farmer to withstand the risk that arises due to financial loss. Risk can be
quantified by statistical techniques like coefficient of variation (CV), standard deviation (SD) and
programming models. The words risk and uncertainty are synonymously used.
Some sources / types of risk
1. Production/ physical risk.
2. Technological risk.
3. Personal risk
4. Institutional risk
5. Weather uncertainty.
6. Price risk
Repayment capacity under risk
Deflated gross Income- (working expenses excluding the proposed crop loan+ family living expenses
+ other loans due+ miscellaneous expenditure)
Measures to strengthen risk bearing ability
1. Increasing the owner’s equity/net worth
2. Reducing the farm and family expenditure.
3. Developing the moral character i.e. honesty, integrity, dependability and feeling the responsibility
etc. All these qualities put together are also called as credit rating.
4. Undertaking the reliable and stable enterprises (enterprises giving the guaranteed and steady
income)
5. Improving the ability to borrow funds during good and bad times of crop production.
6. Improving the ability to earn and save money. A part of the farm earnings should be saved by the
farmer so as to meet the uncertainty in future.
7. Taking up of crop, livestock and machinery insurance

4.2 Credit Assessment: The 5 Cs of Credit

The 5Cs of Credit that must be considered in lending are:
(i) Character
(ii) Capacity
(iii) Capital
(iv) Condition and
(v) Credit worthiness

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(i) Character: The term “Character” implies credit characters related to the qualities of individuals
which make him conscious of the debt obligations. These characters include the borrowers’ moral
characters like honesty, integrity, sense of responsibility and trustworthiness. It is one of the basic
cornerstones in assessing the risk-bearing ability of the borrower. Borrowers with highly rated credit
character can withstand unforeseen events and save themselves insolvency. A borrower noted for
timely repayment shows a reflection of an ideal credit character. Character is also correlated with the
returns and repayment capacities of the borrowers.
(ii) Capacity: Shows the capacity of the borrower to pay his debts as at when due. Since payments
often depend in part on income, the capacities of borrowers to pay will depend on the income rather
than on savings.
(iii) Capital: Capital refers to the equity or net worth of a farm business. It assures that funds are
available to repay loans if character, capacity prove to be inadequate. Capital also represents one of
the cornerstones for measuring the risk bearing ability of the borrower.
(iv) Condition: Also signifies the financial conditions of the borrower which has direct relevance
with the risk bearing ability as well.
(v) Credit worthiness: This relates to the perfect understanding between the lender and the borrower
in credit transactions. This is in fact prima-facie requirement in obtaining credit by the borrower.

4.3 principles of farm finance/7 Ps of farm credit

The increased role of financial institutions due to technological changes on agricultural front
necessitated the evolving of principles of farm finance, which are expected to bring not only the
commercial gains to the bankers but also social benefits. The principles so evolved by the
institutional financial agencies are expected to have universal validity. These principles are popularly
called as 7 Ps of farm credit and they are,
1. Principle of productive purpose.
2. Principle of personality.
3. Principle of productivity.
4. Principle of phased disbursement.
5. Principle of proper utilization.
6. Principle of payment and
7. Principle of protection.
1. Principle of productive purpose:
This principle refers that the loan amount given to a farmer - borrower should be capable of
generating additional income. Based on the level of the owned capital available with the farmer, the
credit needs vary. The requirement of capital is visible on all farms but more pronounced on
marginal and small farms. The farmers of these small and tiny holdings do need another type of
credit i.e. consumption credit, so as to use the crop loans productively (without diverting them for
unproductive purposes). Inspite of knowing this, the consumption credit is not given due importance
by the institutional financial agencies. This principle conveys that crop loans of the small and
marginal farmers are to be supported with income generating assets acquired through term loans. The
additional incomes generated from these productive assets add to the income obtained from the
farming and there by increases the productivity of crop loans taken by small and marginal farmers.
The examples relevant here are loans for dairy animals, sheep and goat, poultry birds, installation of
pumpsets on group action, etc.

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2. Principle of personality:
The 3Rs of credit are sound indicators of credit worthiness of the farmers. Over the years of
experiences in lending, the bankers have identified an important factor in credit transactions i.e.
trustworthiness of the borrower. It has relevance with the personality of the individual. When a
farmer borrower fails to repay the loan due to the crop failure caused by natural calamities, he will
not be considered as willful – defaulter, whereas a large farmer who is using the loan amount
profitably but fails to repay the loan, is considered as willful - defaulter. This character of the big
farmer is considered as dishonesty. Therefore the safety element of the loan is not totally depends up
on the security offered but also on the personality (credit character) of the borrower. Moreover the
growth and progress of the lending institutions have dependence on this major influencing factor i.e.
personality. Hence the personality of the borrower and the growth of the financial institutions are
positively correlated.
3. Principle of productivity:
This principle underlines that the credit which is not just meant for increasing production from that
enterprise alone but also it should be able to increase the productivity of other factors employed in
that enterprise. For example the use of high yielding varieties (HYVs) in crops and superior breeds
of animals not only increases the productivity of the enterprises, but also should increase the
productivity of other complementary factors employed in the respective production activities. Hence
this principle emphasizes on making the resources as productive as possible by the selection of most
appropriate enterprises.
4. Principle of phased disbursement:
This principle underlines that the loan amount needs to be distributed in phases, so as to make it
productive and at the same time banker can also be sure about the proper end use of the borrowed
funds. Ex: loan for digging wells. The phased disbursement of loan amount fits for taking up of
cultivation of perennial crops and investment activities to overcome the diversion of funds for
unproductive purposes. But one disadvantage here is that it will make the cost of credit higher.
That’s why the interest rates are higher for term loans when compared to the crop loans.
5. Principle of proper utilization:
Proper utilization implies that the borrowed funds are to be utilized for the purpose for which the
amount has been lent. It depends upon the situation prevailing in the rural areas viz., the resources
like seeds, fertilizers, pesticides etc., are free from adulteration, whether infrastructural facilities like
storage, transportation, marketing etc., are available. Therefore proper utilization of funds is possible,
if there exists suitable conditions for investment.
6. Principle of payment:
This principle deals with the fixing of repayment schedules of the loans advanced by the institutional
financial agencies. For investment credit advanced to irrigation structures, tractors, etc the annual
repayments are fixed over a number of years based on the incremental returns that are supposed to be
obtained after deducting the consumption needs of the farmers. With reference to crop loans, the loan
is to be repaid in lumpsum because the farmer will realize the output only once. A grace period of 2-
3 months will be allowed after the harvest of crop to enable the farmer to realize reasonable price for
his produce. Otherwise the farmer will resort to distress sales. When the crops fail due to
unfavourable weather conditions, the repayment is not insisted upon immediately. Under such
conditions the repayment period is extended besides assisting the farmer with another fresh loan to
enable him to carry on the farm business.

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7. Principle of Protection:
Because of unforeseen natural calamities striking farming more often, institutional financial agencies
cannot keep away themselves from extending loans to the farmers. Therefore they resort to safety
measures while advancing loans like
- Insurance coverage
- Linking credit with marketing
- Providing finance on production of warehouse receipt
- Taking sureties: Banks advance loans either by hypothecation or mortgage of assets
- Credit guarantee: When banks fail to recover loans advanced to the weaker sections, Deposit
Insurance Credit Guarantee Corporation (DICGC) reimburses the loans to the lending agencies on
behalf of the borrowers

4.4 Credit instruments

4.4.1 Promissory Note
A promissory note is the primary legal document in most loan contract. It is the written promise of
the borrower to repay the loan. When advancing loan funds, the lender receives in exchange a note
signed by the borrower promising to pay the lender a certain stated principal with interest on a
certain date as specified in the note. The dominant position of the note in all credit transactions
should be clearly understood. There may be tendency to overlook this small form that has much less
printed matter that many other legal document, but such as oversight may prove costly, since the
borrower’s signature at the bottom of a note is a direct obligation holding the borrower liable for
payment of the loan according to the stated terms. In case of default and failure of the proceeds from
sale of the collateral to cover the amount due, the borrower usually is till liable for the unpaid
balance, and the lender may have other nonexempt property of the borrower sold to satisfy the
deficiency. If the lender requires an additional signature on the note, a common condition where the
borrower is a young farmer with little capital, the cosigner should study the provisions of the note as
carefully as if acting as the borrower, since in effect the cosigner is liable for the payment if the
borrower defaults. Notes may be unsecured or they may be secured by real property, personal
property or both.
4.4.2 Mortgages
This is ranked second to the promissory note. It is not only an additional note but a complement. A
mortgage is a list of certain property set aside to guarantee the payment of a loan which is set in a
promissory note. Mortgages are identical to promissory note in their chief provisions. They are also
sometime called indentures. The mortgage in additions to identifying the property to back up the
promissory note contains provisions which establish a priority of claims among lenders according to
the filling or according to the mortgage in a court of law. Sometimes a bond and not a promissory
note accompany the mortgage but the general effect is the same. The transaction will be publicised
so that other lenders and other members of the public will know about it.
There are Several Types of Mortgages
i. Real Estate Mortgage: Real estate in law is land and landed property. The important feature of
real-estate mortgage is the unchanging character of the security.
ii. Chattel Mortgage: These are mortgage on movable property such as animals.
4.4.3 Purchases on Contract

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This is sometimes simply referred to as hire purchase contract. This involves the transfer of the
property to the buyer or the purchaser, with the title of the property remaining with the seller until
the last installment is paid. Hence purchase on contract is sometimes referred to as conditional sales
contract.

LECTURE FIVE: EFFECTIVE DEMAND FOR AGRICULTURAL CREDITS

*Demand for agricultural credit is the willingness and ability of farmers to access existing sources of
funds to meet farm investment needs.
*Effective demand for agricultural credit can be defined as the minimum volume of credit that would
yield a minimum incremental growth in the profitability of agricultural production units which may
be greater or equal to the cost f credit.
*It is the demand that is backed up by sufficient ability to repay with zero default risk.
Note that demand for credit goes beyond a desire to have a loan because it is available or because
livelihood strategies are constrained to a desire to use the loan to initiate farm business or improve
existing commercial farm business.
*Repayment ability of the borrower is therefore crucial to effective demand for agricultural credit.
To seek social optimum growth and equity, effective demand must be stimulated by a set of growth
inducing inputs in the production environment. Based on the need for credits, farmers’ decision to
borrow and not to borrow will depend on some indicators of demand which could be accessed
through four dimensions of the borrowers’ activities.
These are:
i. Financial impact
ii. Economic impact
iii. Technological impact and
iv. Social impact
On the Borrowers’ side, effective demand for credit requires that farmers make a choice between
investing in one agricultural activity or the other or investing in an alternative nonagricultural
project. It may also require decision to choose between consumption and production in order to
achieve a social optimum of generating income for repayment or returns to institutional cost of the
credit programme.
From the policy formulation and implementation point of view, promoting effective demand
requires the consideration of factors and a balanced judgment on whether to invest on institutional
cost of credit delivery programme or to invest on some alternative development-enhancing
programmes whose outputs could be inputs into farmers’ production.
On the supply side, for credit to induce an overall development, it is important to consider the extent
to which new entrants into farming business can be included in the credit programmes as they may
likely have no repayment ability. There is also a need to consider how liberalized credit markets and
growth-inducing credit facilities can affect the agricultural investments to be established to promote
effective demand for credit to the benefits of both the lenders and the borrowers.

Problems of Effective Demand for Credit in Cameroon.

(i) Availability of finance to back up the demands for credit
(ii) Borrowers’ willingness and abilities to access existing credit delivery programmes
(iii) Socio-economic and cultural issues (Demand side)

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(iv) Capacity of the existing credit sources to meet up with demands
(v) Policy environment under which credit options are provided
(vi) Rigidity of the formal lending sources
(vii) Unpredictable profits
(viii) No secured tenure to land and other assets
(ix) Illiteracy of majority of the farmers
(x) Target groups are not always farmers
(xi) Cumbersome procedure of application for the credit
(xii) High level of centralized administration which restricts awareness and access to credit
(xiii) Problems associated with infrastructures
(xiv) Poor repayment culture of most farmers. e.t.c

LECTURE SIX: REPAYMENT PLANS

Payment Type: Payment type refers to the method of repayment. Payments on line-of-credit
financing generally occur when the borrower has surplus funds. The lender usually establishes a
payment schedule for intermediate- and long-term loans. A borrower should ask the lender to
produce a copy of a payment schedule that specifies principal and interest payments over the life of
the loan. The borrower can then compare payment patterns on different loans.

A borrower should be aware of any demand clauses in a note or loan agreement. A demand clause is
a provision that allows the lender to demand payment at any time. Even though the demand
provisions are seldom carried out, a borrower should be comfortable with paying the loan upon
demand, especially in times of economic uncertainty.

There are three common payment types. One payment type for intermediate- or long-term loans is
the fixed payment method. This method requires a fixed payment (interest plus principal), which
repays a loan over a specified period of time at a specified interest rate. This repayment process if
often referred to as equal amortization. Part of each payment is allocated to principal and part to
interest, with successive payments retiring more and more principal.

Another way to calculate the payment on an intermediate- or long-term loan is fixed principal
payment with interest due on the unpaid balance. The fixed principal amount is usually calculated
by dividing the loan amount by the total number of payments. Under this method, the initial
payments of principal and interest are the largest, and the ability to cash flow these payments must be
considered. This method of payment requires less total interest over the life of the loan because more
of the principal is repaid earlier in the loan.

Table 1 shows a comparison between the fixed payment method and the fixed principal method. The
loan is for $100,000, to be repaid over five years at 10% interest. The payment remains constant
($26,380) with the fixed payment method. With the fixed principal method, the annual payment
ranges from $30,000 in year 1 to $22,000 in year 5. Total interest payments are $1,898 higher with
the fixed payment method.

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A third payment type is a balloon payment loan. Balloon payment loans are relatively shorter-term
loans (e.g., five years). At the end of the period, the entire unpaid balance of the loan is due; the
principal must either be paid in full or new loan terms must be negotiated. The initial payments are
usually based on a longer amortization period (e.g., 10 to 30 years) under the assumption that the
loan will be paid off, renewed or financed at maturity. If interest rates fall and credit conditions
improve, a borrower could negotiate more favorable loan terms at renewal. On the other hand, if
interest rates rise or credit tightens, the loan terms may become less favorable. In addition, the
borrower’s risk is considerably higher since the lender may decide not to renew the loan at maturity.
Borrowers considering balloon payment loans need to inquire about the fees added each time the
loan is renewed.

Table 1. Fixed payment vs. fixed principal.

Loan Terms: $100,000, five years, 10% interest, one payment per year.
Fixed Payment Method Fixed Principal Method
YearBeginning Principal Interest Total Ending Beginning Principal Interest Total Ending
Balance Payment Payment Payment Balance Balance Balance Payment Payment Balance
1 100,000 16,380 10,000 26,380 83,620 100,000 20,000 10,000 30,000 80,000
2 83,620 18,018 8,362 26,380 65,602 80,000 20,000 8,000 28,000 60,000
3 65,602 19,820 6,560 26,380 45,782 60,000 20,000 6,000 26,000 40,000
4 45,782 21,802 4,578 26,380 23,980 40,000 20,000 4,000 24,000 20,000
5 23,980 23,980 2,398 26,378 0 20,000 20,000 2,000 22,000 0
Total 100,000 31,898 131,898 NA NA 100,000 30,000 130,000 NA

Table 2 illustrates a balloon payment loan. Payments in the first four years are identical to a 20-year
amortized loan. After the fifth payment, $10,660 of the loan has been paid off, leaving an
outstanding loan balance of $89,340. This amount must be paid in full or refinanced at interest rates
prevailing in year 5. Although the lender may refinance the balloon payment loan, there is no legal
obligation to do so. The decision to renew will be based on the lender’s consideration of credit and
economic factors as they apply at the time of renewal. A borrower selecting a balloon payment loan
should be comfortable with risks associated with balloon payment loans. If a borrower is considering
refinancing with a different lender upon maturity, additional administrative and closing costs may be
incurred.

Table 2. Payment pattern of a balloon payment loan.

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Loan Terms: $100,000, five years, 10% interest, one payment per year based on a 20-year amortization.
Year BeginningPrincipal Interest Payment Total Payment Ending Balance
Balance Payment
1 100,000 1,746 10,000 11,746 98,254
2 98,254 1,921 9,825 11,746 96,333
3 96,333 2,113 9,633 11,746 94,220
4 94,220 2,324 9,422 11,746 91,898
5 91,896 2,556 9,190 11,746 89,340
5 (Balloon Payment) 89,340 89,340 0 89,340 0

Interest Rate

Since it is the visible “price tag” of a loan, the interest rate is often used to compare loans. Loans
carry fixed, adjustable or variable interest rates. A fixed rate loan carries the same interest rate until
the loan is paid off. A variable or adjustable rate loan has provisions to change the interest rate based
on changes in market rates of interest, a specified index or other factors determined by a lender.
Interest rates on adjustable rate loans or mortgages can only change at intervals specified in a not or
loan agreement. For example, the interest rate on a five-year adjustable rate mortgage can change
once every five years.

A variable rate loan may also designate intervals in which interest rates may change, but in some
variable rate loans a change in the interest may be at the discretion of the lender. If a borrower has a
variable or adjustable rate loan, he or she should know how often and how much the interest rate
may change. The borrower should also be able to calculate how changes in interest rates affect the
loan payment. A borrower should ask the lender to estimate the scheduled payment at various rates
of interest. The borrower should be comfortable with the uncertainty involved with potential interest
rate changes. If not, the borrower may request loan terms that reduce the interest rate risk.

If the interest rate on a variable or adjustable rate loan is linked to a specified index rate, a lender
typically adds a margin above the index rate to determine the interest rate. For example, if the index
rate is 9% and the margin is 2%, the interest rate on a variable rate or adjustable rate loan is 11%. If
the index rate changes to 11% in the next adjustment period, the interest rate charged will be 13%.

Many characteristics of variable and adjustable rate loan differ among lenders. The interest rate
index (if any), margin, length of adjustment period and caps (upper limits) are the major
distinguishing features. These features may be negotiable.

Interest rate index: The variable of adjustable interest rate is sometimes linked to an interest rate
index. Many lending institutions use their average cost of funds or another internal rate as the basis
to price loans. Other common indices include 1-year Treasury securities rates, 90-day Treasury bills,
prime rate charged at money center banks, federal funds rate and the London Interbank Offer Rate
(LIBOR). Differences between the indices can be substantial. Federal funds rates and 90-day
Treasury bill rates can change every day, while the prime rate changes less frequently. A borrower
should ask the lender about historical patterns of the index rate. In addition, if the lender is using the
institution’s internal rate, a borrower should ask how often the lender changes this rate.

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Margin: The margin refers to the percentage points that the lender adds to the rate index to
determine the rate charged to the borrower. The margin covers the costs of administering the loan, a
risk premium, and a profit margin for the lender. The note or loan agreement will state if the margin
is to remain constant over the maturity of the loan.

Length of adjustment period: The adjustment period is the length of time before the lender can
change the borrower’s interest rate. At the end of each adjustment period, the interest rate may be
adjusted to reflect changes in the index (if an index is used). The note may allow for other terms of
the loan to change at each adjustment period.

Caps: Rate caps may be associated with variable or adjustable rate loans. They limit how much the
interest rate can change at each adjustment period. Many loans also have life-of-loan rate caps which
limit interest rate movements over the entire life of the loan. Often a cap may be purchased as an
optimal feature of the loan.

A borrower should be aware of each of these factors affecting a variable or adjustable rate loan.
Moreover, the combination of the factors and the resulting implications must be considered. For
example, if a lender has a volatile interest rate index, a borrower should consider some type of cap.
Lenders will negotiate on the different variable and adjustable rate features. For example, a lender
may lengthen the adjustment period in exchange for a higher margin. A borrower should feel
comfortable with the variable or adjustable rate features and be willing to discuss changes in a loan
package.

Fees and Service Charges

As a general rule, loan fees or “points” are charged at a the time the loan is made. A point is 1% of
the amount loaned. In addition, there may be other service charges for which the lender will require
reimbursement. Service charges and fees are typically charged for:

 real estate appraisals,

 credit searches,

 legal costs,

 recording mortgages and deeds,

 mortgage title insurance premiums and

 title searches.

Fees and service charges increase the borrower’s cost. Figure 1 shows the estimated increased cost
over the life of a loan for one point paid at origination on a 10% loan with annual payments. For
example, the effective interest rate on a 7-year loan increase about 0.30% (30 basis points) for one
point paid at origination. In other words, if the stated interest rate on a 7-year loan is 10% and the
lender charges a one-point origination fee, the effective interest rate to the borrower would be
approximately 10.30%. Using this technique, a borrower could compare the effective interest rates

19
on various loan products. A loan comparison FAST tool can also be used to estimate more precisely
the impact of fees on the costs of loans.

Some lenders will reduce the interest rate in exchange for a fee at origination. This is called a rate
buydown. A borrower could also use Figure 1 to estimate the potential benefit from a rate buy down.
For example, suppose a lender offers to reduce a borrower’s interest rate on a fixed-rate loan by
0.20% (20 basis point) for 1 point at origination. The cost is the same if the loan is expected to be
paid off in 12 to 13 years (intersection of 0.20% and line). If the loan is expected to be paid off in
more than 13 years, a borrower should benefit by the rate buydown, while a borrower’s anticipated
return would be less if the loan is expected to be paid off in less than 12 years. This graph is only an
approximation of a 10% fixed payment loan. The break-even point would be different if the loan
were to be paid before maturity. A borrower should ask the lender to estimate the break-even points
for each loan alternative.

Stock Purchases and Compensating Deposit Balances

Farm Credit System lenders usually require a stock purchase. The stock requirement may be as low
as 2% of the loan amount or a maximum of $1,000. A stock purchase increases the effective interest
rate on the loan. The effect of the stock purchase on the effective interest rate diminishes as the loan
maturity lengthens and/or loan size increases. The purchase of stock is a financial investment in the
issuing institution which is typically paid back at loan maturity, but the lender is not obligated to do
so.

A compensating deposit balance is a minimum deposit balance that is sometimes required by a bank
from a borrower. The balance is usually expressed as a percentage of the total loan commitment
and/or a stipulated percentage of the amount of commitment actually used by the customer. In some
cases, compensating balances can be used as a negotiating device by the borrower.

Payment Frequency

The frequency of payments differs among loans. Typically, intermediate- and long-term loans are
structured with monthly, quarterly, semiannual or annual payments. More frequent principal
payments generally reduce the total interest paid over the life of the loan. A similar factor to consider
is the timing of the payments. Obviously, it is preferable to have payments which correspond with
high cash inflows. A borrower should establish a payment pattern with a lender that coincides with
his or her cash flow.

Figure 1. Increased cost of loan per point origination fee.

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Note: Figure 1 will shift upward if interest rates are higher than 10%, while the graph will be slightly
lower if interest rates are less than 10%. Figure 1 does not account for the time value of the tax
difference between points paid at origination and interest paid over the life of the loan.

Maturity

Loan maturity is simply the time until the loan is fully due and payable. A borrower should evaluate
his or her ability to generate cash to repay debt when comparing loans with different maturities. As a
rule of thumb, a borrower should not select a loan maturity that is longer than the anticipated life of
the asset being financed. Shorter maturities result in lower total interest payments over the life of the
loan and more rapid accumulation of equity in the asset being financed. In contrast, loans with longer
maturities will have lower loan payments and, therefore, free up cash for other uses. Thus, tradeoffs
between shorter and longer loan maturities should be carefully evaluated.

Table 3 shows annual payments among loans of different maturities and interest rates. For example,
the annual payments on a $100,000, 20-year loan at 10% would be $11,746. The payments on a
similar 30-year loan would be $10,608. A borrower could also use Table 3 to estimate the change in
annual payments as interest rates changed.

Table 3. Annual loan payments for $100,000 loan, fixed-payment method.

Annual Payments
  Interest Rate
Years to Maturity 8% 10% 12% 14% 16% 18%
5 25,046 36,380 27,741 29,128 30,541 31,978
10 14,903 16,275 17,698 19,171 20,690 22,251
20 10,185 11,746 13,388 15,099 16,867 18,682
30 8,883 10,608 12,414 14,280 16,189 18,126

Collateral Requirements

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Collateral refers to the assets pledged as security in a loan transaction. The legal documents
representing a lender’s interest in collateral include a mortgage or deed of trust in the case of farm
real estate loans and a security agreement for operating and intermediate-term loans. Nearly all
farm real estate loans are secured by a mortgage or deed of trust on a tract of land. Operating loans
and intermediate-term loans may be secured or unsecured, although secured loans are more common.
Unsecured loans generally involve smaller loans to financially strong borrowers who usually are
long-term customers of the lending institution.

Intermediate-term loans generally are secured by the asset being purchased. Examples are tractors,
combines, equipment, facilities and breeding livestock. Operating loans usually are secured by
current assets and sometimes by intermediate assets as well. Examples of collateral for operating
loans are farm supplies, crop and livestock inventories, growing crops, government payments and
deposit accounts. A blanket filing may be used on a line-of-credit financing so that the security
agreement applies to essentially all of the current and intermediate assets and, if stipulated, to
property acquired in the future as well.

A security agreement usually includes covenants about selling, insuring and/or maintaining
collateral. Many security agreements for real estate purposes now include provisions regarding the
storage and disposal of hazardous wastes. A borrower should be aware of the procedures and
notifications that need to be made upon selling or modifying assets used as collateral.

A borrower should also be aware of the lender’s right to collateral upon default. A security
agreement or mortgage will specifically outline the lender’s and borrower’s rights upon default.

Prepayment Penalties

A borrower should be aware of prepayment penalties. A prepayment penalty is a fee charged by a

lender when a loan is paid prior to its maturity. Prepayment penalties vary significantly among
lenders. Prepayment penalties will increase the cost of refinancing a mortgage and reduce the
flexibility of changing loan alternatives, such as refinancing if interest rates decline.

Refinancing

As interest rates fall, refinancing may become more attractive. Better service, lengthening of
maturity, more favorable noninterest lending terms, and customer dissatisfaction may also motivate a
borrower to refinance. In addition to the interest rate reduction, a borrower should estimate fees and
penalties that would result from refinancing the loan. These fees and penalties may overcome any
interest rate savings. Furthermore, if the borrower is switching from a fixed-rate loan to a variable- or
adjustable-rate loan, he or she should evaluate the differences in risk associated with these loans.

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Loan Conversion: A conversion option provides the ability to convert from one type of loan to
another (e.g., from fixed rate to variable, and vis a versa) at any time or at the end of an adjustment
period. This option may require a fee.

Reporting Requirements

The detail and frequency of financial reports required from a borrower will differ from lender to
lender and by type and size of loan. Many real estate lenders require annual financial statements.
Others only require statements when originating or renegotiating a loan. The borrower should feel
comfortable with the financial statement requirements, but choosing a lender that requires the fewest
reports may not be in the borrower’s best interest. Most borrowers are already preparing periodic
financial reports for management purposes. Thus, reasonable reporting requirement should not be a
significant factor in the borrower’s choice of lender.

The financial statements include a balance sheet formulated at the same time each year and an
income statement. A cash flow budget may also be helpful. Using accurate and verifiable data is
important.

Credit Evaluation Procedures

Many agricultural lenders analyze the creditworthiness of agricultural borrowers using a combination
of judgment and formal credit scoring models or risk assessment worksheets. This approach seeks to
combine various measures of business performance (e.g., profitability, solvency, liquidity, repayment
history and collateral) with other information about the borrower to reach an overall credit score.
This credit score may be used in making loan decisions, determining the borrower’s interest rate,
deciding about loan supervision and monitoring business performance. Borrowers can aid in the
evaluation process by keeping comprehensive financial records (e.g., balance sheets, income
statements, flow of funds summaries) and presenting this information to the lender in a timely, well-
organized and thoroughly documented fashion. Annual statements should be prepared at the same
time each year to allow for more appropriate comparisons over time. In turn, the borrower can ask a
lender to review the results of the credit evaluation process so that both parties clearly understand the
strengths and weaknesses of the farm business, and thus develop more effective financial plans in the
future.

Risk Management

These are practices by borrowers that help to stabilize farm income and improve the likelihood of
successful loan repayment. Examples include enterprise diversification, resistant seed varieties, crop
insurance, holding financial reserves, limits on borrowing, crop share leases, off farm work, and
marketing practices such as forward contracting, frequency of sales, futures and option contracts and
others. Lenders may respond to these practices with more favorable financing terms, lower interest
rates, and access to credit.

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Late-Payment Penalties and Foreclosure Provisions

Even though most borrowers plan to make timely loan payments, unforeseen circumstances
sometimes results in late payments. A borrower should compare the penalties associated with late
payments and grace periods that are specifically written in loan documents. A borrower should also
be aware of the conditions under which the loan is considered in default.

Other Considerations

It is beyond the scope of this guide to describe rating techniques for lenders or their institutions;
however, a borrower should seek to develop confidence and trust with both lenders and lending
institutions.

The repayment of term loans (i.e. medium term loans and long term loans) differs from that of short
term loans because they are characterized by their partially liquidating nature. These loans are
recovered by a given number of installments depending up on the nature of the asset and the amount
advanced for the asset under consideration.
There are six types of repayment plans for term loans and they are
1. Straight-end repayment plan or single repayment plan or lumpsum repayment plan
2. Partial repayment plan or Balloon repayment plan
3. Amortized repayment plan
a) Amortized decreasing repayment plan
b) Amortized even repayment plan or Equated annual installment method
4. Variable repayment plan (or) Quasi-variable repayment plan
5. Optional repayment plan
6. Reserve repayment plan (or) Future repayment plan
1. Straight-end Repayment Plan or Single Repayment Plan (or) Lumpsum Repayment Plan
The entire loan amount is to be cleared off after the expiry of stipulated time period. The principal
component is repaid by the borrower at a time in lumpsum when the loan matures, while interest is
paid each year.
2. Partial repayment plan or Balloon repayment plan
Here the repayment of the loan will be done partially over the years. Under this repayment plan, the
installment amount will be decreasing as the years pass by except in the maturity year (final year),
during which the investment generates sufficient revenue. This is also called as balloon repayment
plan, as the large final payment made at the end of the loan period (i.e. in the final year) after a series
of smaller partial payments.
3. Amortized repayment plan:
Amortization means repayment of the entire loan amount in a series of installments. This method is
an extension of partial repayment plan. Amortized repayment plans are of two types
a) Amortized decreasing repayment plan
Here the principal component remains constant over the entire repayment period and the interest part
decreases continuously. As the principal amount remains fixed and the interest amount decreases, the
annual installment amount decreases over the years. loans advanced for machinery and equipment

24
will fall under this category. As the assets do not require much repairs during the initial years of loan
repayment, a farmer can able to repay larger installments.
b) Amortized even repayment plan
Here the annual installment over the entire loan period remains the same. The principal portion of the
installment increases continuously and the interest component declines gradually. This method is
adopted for loans granted for farm development, digging of wells, deepening of old wells,
construction of go-downs, dairy, poultry units, orchards etc.
Fig 2: Amortized even repayment plan
The annual installment is given by the formula
I = B* i/1-(1+i)-n
Where I= annual installment.
B= principal amount borrowed in Rs.
n= loan period in years
i= annual interest rate
4. Variable repayment plan or Quasi-variable repayment plan
As the name indicates that, various levels of installments are paid by the borrower over the loan
period. At times of good harvest a larger installment is paid and at times of poor harvest smaller
installment is paid by the borrower. Hence, according to the convenience of the borrower the amount
of the installment varies here in this method. This method is not found in lending of institutional
financial agencies.
5. Optional repayment plan:
Here in this method an option is given for the borrower to make payment towards the principal
amount in addition to the regular interest.
6. Reserve repayment plan or Future repayment plan
This type of repayment is seen with borrowers in areas where there is variability in farm income. In
such areas the farmers are haunted by the fear of not paying regular loan installments. To avoid such
situations, the farmers make advance payments of loan from the savings of previous year. This type
of repayment is advantageous to both the banker and borrower. The bankers need not worry
regarding loan recovery even at times of crop failure and on the other hand borrower also gains, as
he keeps up his integrity and credibility.

LECTURE SEVEN: TIME VALUE OF MONEY

The saying is “A bird in hand is worth two in the bush.” The value of a dollar received today is
worth more than a dollar received a year from now. Why? Money received now can be invested and
earn interest, or it could be consumed. Investing is trading dollars today for dollars in the future.
Borrowing is trading future dollars for dollars today.

Key concepts:

Time line YEARS 0 1 2 3 YEARS

_______________________________________

Value $1 $1.10 $1.21 $1.33 10% Compound return

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The time line shows that by compounding $1 today it will grow to $1.21 in 2 years and $1.33 in 3
years. This is called finding future value.

Discounting is the opposite of compounding. Discounting the future value of $1.33 in year 3 to
period zero of $1 is called finding a present value.

The interest rate r is the rate at which a cash flow grows in the future. Compound interest is earning
interest on interest. In the above example, simple interest of 10% would provide an investor with a
return of 10 cents per period.

The formula to express the concept of compounding and future value is:

FVn = PV (1 + r)n

FV3 = $1 (1.10)(1.10)(1.10) = $1.33 or $1(1.10)3 where n = 3 years

Your financial calculator will help you solve for any of 4 variables: future value (FV), present value
(PV), time periods (n) and the interest rate r. There is another factor to consider in addition. This is
the number of compounding periods m. The financial calculator requires you to set the number of
periods using the key P/Y. You know that daily compounding will produce a higher future value
than annual compounding for example.

PRESENT VALUE TABLES: Please become familiar with Tables B, C , D, and E in the back of
your text. While exams will use the calculator, we will do problems using the tables to help you
understand what the calculator is doing.

FV CONCEPTS: 1. The higher the interest rate r the higher the future value

2. The longer the time period n the higher the future value
3. The more frequent the compounding m the higher the FV

As noted above, Discounting is the process of taking a Future Value (FV) and placing it in Present
Value terms. In finance this concept is used in a variety of applications that we will study in this
course. For example:

 The value of an office building is the discounted present value of the rents
received for n years.
 The value of a common stock (using a dividend discount model) is the
expected future dividends paid for n years into the future.
PV = FVn

(1 + r)n

We saw above that $1 grew to $1.33 in 3 years at 10% compounded. Conversely, the PV of $1.33
received 3 years from now is $1

PV CONCEPTS: 1. The higher the interest rate r the lower the present value

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 2. The longer the time period n the lower the present value
3. The more frequent the compounding the lower the present value
So far we have dealt with a simple example of single (or lump sum) cash flows

What about multiple cash flows?

A constant cash flow over time is called an ANNUITY. This contrasts with a lump sum.

The present value of an annuity (PVA) can be derived from the following formula:

PVA = FV + FV + FV

( 1 + r)1 (1 + r)2 ( 1 + r)3

Let us say you receive a paycheck of $500 per week. That is an annuity which pays you a total of
$26,000 per year (52 weeks).

The future value of an annuity FVA can be derived using the PMT key on your financial calculator.
The PMT is a recurring cash flow of the same size received over time (n). Let us say you can save
$300 per month. At an interest rate r of 15% per annum compounded, how much money would you
have in 30 years? In 25 years? n = 30 x 12 = 360 months) With the financial calculator, you will
learn how to set the calculator for monthly compounding by setting P/Y to 12. On the calculator you
will set P/Y to 12 meaning this is a monthly payment (12 times per year).

A football player is offered a 3 year contract which will pay $5 today (lump sum) or $ 1 million at
the end of year 1, $2 million at the end of year 2, and $3 million at the end of year 3. Assuming an
interest rate r of 5%, which offer should he accept?

The PV of the $5 million lump sum is $5 million since it is received today. What is the PV of 3
uneven cash flows totaling $6 million over 3 years? The answer is $5,357,952.

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