Mr. Octavio Perez has completed an application for a three-year personal loan in the amount of $7,000.00 (see Exhibit 1). In the application he indicated that the money would be used to repay (consolidate) various debts and to make a down payment on a 1987 Mazda car which he needs to buy for transportation to and from work.

Mr. Perez arrived in the United States two years ago. He worked in New York, Chicago, and Boston before moving to Atlanta, Georgia. He has been in Atlanta for three months and is currently residing at his brother's apartment. Two weeks ago he started working at Blue Sky Airlines and plans to rent his own apartment at the beginning of next month.

Mr. Perez's application was handed over to Mr. Cash, a consumer lending officer at the Stone Mountain branch of Big Bank of Atlanta. After going over the loan application, Mr. Cash asked Mr. Perez a few details about his job, his new apartment, and the car he was going to purchase. Mr. Perez was very excited about his new job, which provided a net monthly income of $1,238.00 and good benefits. He was optimistic about his future with the company and felt that if he did a good job, he had opportunity for

advancement.

Mr. Perez's apartment rent amounted to $350.00 per month and part of the loan would be used for the first month, last month, and one month deposit up front. Another portion of the loan ($1,000.00) was going to be used for a down payment on the car which was selling for $6,000.00. The Mazda dealer would finance $5,000.00 for three years at 14 percent, resulting in monthly payments of approximately $170.00.

The remaining amount of the loan was going to be used to pay-off the two utility companies and the $2,450.00 he owed the credit union. Mr. Perez went on to say that his brother, Eduardo, had maintained an account at the Big Bank for several years and, if needed, he would offer his guarantee for the loan. Mr.

Cash thanked Octavio for coming to Big Bank, and assured him that he would have an answer for him within four days.

Soon after Mr. Perez left, Mr. Smith, the personnel director at Blue Sky Airline, walked in the bank to make a transaction. Mr. Cash took this opportunity to find out more about Mr. Perez. However, Mr.

Smith only volunteered that Mr. Perez had in fact been recently hired, and confirmed the salary reported by Mr. Perez on the application.

With this information at hand, Mr. Cash proceeded to evaluate the loan request. He thought appropriate to begin the analysis by listing the strengths and weaknesses of the applicant, and by constructing a typical monthly budget of income and expenses to determine Mr. Perez's disposable income (net income after expenses). If the loan were to be approved it would be made on an installment basis at the rate of 1.5 percent per month (18 percent per annum). This meant a monthly payment in the amount of $253. Mr. Cash also figured out that Mr. Perez's average monthly food bill would come to $150, and his utility and car expenses to about $100 each. Mr. Cash was well aware of the fact that a minimum coverage ratio of disposable income to loan amount of 20 percent was a bank requirement for all personal

loans

Octavio Perez

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Another issue that Mr. Cash must consider is the usage of the loan--that is, whether the amount of the loan requested is sufficient to cover the proposed usage by the borrower. Occasionally consumers make poor estimates of their actual credit needs. If these estimates are too high, the bank's risk exposure is increased; if too low, borrowers will need additional credit. A credit estimate must be as accurate as possible, for this is the basis of the loan. Hence, we see the importance of a loan usage analysis.

Questions

1. Should Mr. Cash recommend approval of Mr. Perez's loan? Explain your reasoning.

2. Should the bank require that Mr. Perez's brother guarantee the loan? Why or why not?