Demand Loans

A demand loan is a short-term loan that generally has no specific maturity date, where the borrower can make a payment to settle the loan, either in part or full, at any time without any interest penalty, and where the lender can demand repayment in full at any time. A demand loan allows borrowing when needed and repayment when money permits, subject to the following characteristics.

1. Credit Limit. This establishes the maximum amount that can be borrowed.
2. Variable Interest Rate. Almost all demand loans use variable simple interest rates based on the prime rate. Only the best, most secure customers can receive prime, while others usually get “prime plus” some additional amount.
3. Fixed Interest Payment Date. Interest is always payable on the same date each and every month. For simplicity, the payment is usually tied to a checking or savings account, allowing the interest payment to occur automatically.
4. Interest Calculation Procedure. Interest is always calculated using a simple interest procedure based on the daily closing balance in the account. This means the first day but not the last day is counted.
5. Security. Loans can be secured or unsecured. Secured loans are those loans that are guaranteed by an asset such as a building, a vehicle, inventory, accounts receivable, etc. In the event that the loan defaults, the asset can be seized by the lender to pay the debt. Unsecured loans are those loans backed up by the general goodwill and nature of the borrower. Usually a good credit history or working relationship is needed for these types of loans. A secured loan typically enables access to a higher credit limit than an unsecured loan.
6. Repayment Structure. The repayment of the loan is either variable or fixed

• A variable repayment structure allows the borrower to repay any amount at any time, although a minimum requirement may have to be met such as “at least 2% of the current balance each month.” A current balance is the balance in an account plus any accrued interest. Accrued interest is any interest amount that has been calculated but not yet placed (charged or earned) into an account.
• A fixed repayment structure requires a fixed payment amount toward the current balance on the same date each and every month.

Some examples of demand loans include (some of these are not pure demand loans but have many characteristics of a demand loan):

1. Personal Line of Credit (LOC). A demand loan for individuals, a personal line of credit is generally unsecured and is granted to those individuals who have high credit ratings and an established relationship with a financial institution. Because a line of credit is unsecured, the credit limit is usually a small amount, such as $10,000. Repayment is variable and usually has a minimum monthly requirement based on the current balance.
2. Home Equity Line of Credit (HELOC). This is a special type of line of credit for individuals that is secured by residential homeownership. Typically, an amount not exceeding 80% of the equity in a home is used to establish the credit limit, thus enabling an individual access to a large amount of money. The interest rates tend to follow mortgage interest rates and are lower than personal lines of credit. Repayment is variable, usually involving only the accrued interest every month.
3. Operating Loans. An operating loan is the business version of a line of credit. An operating loan may or may not be secured, depending on the nature of the business and the strength of the relationship the business has with the financial institution. Repayment can be either variable or fixed.
4. Student Loans. A loan available to students to pursue educational opportunities. Although these are long-term in nature, the calculation of interest on a student loan uses simple interest techniques. These loans are not true demand loans because a student loan cannot be called in at any time. Repayment is fixed monthly.

Partial Payments of Demand Loans

The borrower can make partial payments on a demand loan at any time, without penalty, to reduce the outstanding balance on the loan. When a partial payment is made, the payment is first used to reduce the interest on the loan. If the interest is completely paid off by the payment, then the remainder of the payment is applied to reduce the principal on the loan. This approach is called the declining balance method.

NOTE

A partial payment may be more or less than the interest that is due on the loan at the time the payment is made. Each time a partial payment is made, the interest due at the time of the payment is calculated.If the partial payment is larger than the amount of interest due, then the interest is paid first and any remaining amount from the payment is used to reduce the principal.
If the partial payment is smaller than the amount of interest due, then the entire payment is applied to interest due. Any interest that is not paid-off by the payment is carried forward to the next payment. Because there is nothing leftover from the payment, nothing is applied to the principal.

References

Business and Financial Mathematics