Oran Hall | Contractual obligations of a bank borrower

QUESTION: I took out a loan in 2008 from a major commercial bank. They used my dad’s land as collateral. In 2012, the loan went bad and they took my dad’s land and put it up for sale. I thought that was the end of it. Little did I know that the interest on the loan would continue until the land was sold and the loan was paid off. I got a letter from the bank stating the land was sold but that I still owed $2.2 million. How is this possible when I only borrowed $800,000? So they sold the land, got $2.4 million, and now they still want more money – all this from just borrowing $800,000. Please advise if this is really possible and why I have to still pay if they already sold the land to pay off the loan.

– Taylor

FINANCIAL ADVISER: You clearly got into something you do not even now understand. When you borrow from a financial institution, your periodic payments cover not just the principal, but interest. Failure to make the full contractual payment on time can have catastrophic consequences as you are learning.

Generally, the interest is paid first and then the principal. In the earlier period, the interest is high because it is computed on a high principal balance. This leaves only a small portion of the periodic payment – usually monthly – to be credited to the principal balance. Thus, the principal sum outstanding tends to fall slowly.

The borrower pays interest on the balance, including arrears, if any, and also is required to pay penalty interest on the arrears – that is, payments not made by the due date – until fully paid. This compounding, or interest upon interest, can potentially cause the debt to exceed the original sum borrowed.

When a loan goes bad, the full amount is required to be paid and is considered to be in arrears until paid in full. The amount owing tends to increase sharply because of the practice of charging penalty interest on the arrears in addition to the regular interest.

In the case where the collateral is to be sold, the fees associated with that transaction, such as those applying to property valuation, are added to the sum outstanding. It is the net proceeds from the sale that are applied to the loan balance, meaning that the expenses incurred in selling the property are deducted from the proceeds. In a case in which a positive balance is left from the sales proceeds after the debt has been satisfied, the borrower receives the surplus.

That is not what happened in your case. The proceeds from the sale of the property clearly fell well short of the sum required to liquidate the debt. In such a case, it is your responsibility to pay the lender the sum required to cover the shortfall. If you fail to do so, interest accrues on the outstanding sum until it is liquidated.

Should you fail to pay, the bank has several courses of action open to it, a common one being that it may sue you for the outstanding sum.

It has been seven years since your loan went bad. That is a long time, a time during which interest has been accumulating, so it should not be surprising that your debt should be so high. It is a hard way to learn that borrowing from a financial institution is not the same as borrowing from a relative or friend.

Before borrowing, it is important to understand well what it entails and to be certain about how the loan is to be serviced. Sometimes unexpected and unforeseen circumstances arise and destroy the best-made plans, so it is important to have a contingent plan in place if possible.

It is also important to give priority to borrowing to fund activities that are capable of generating funds to service the loan first and foremost. In other cases, like buying high-priced personal use items, it may make sense to save as much as possible to increase the deposit and thus reduce how much is to be borrowed. The main drawback here could be a delay in making a purchase and the risk of the price increasing during that time.

It is also important to avoid borrowing unless it is absolutely necessary to do so, but if you have incurred a debt, it is very important to make its repayment a priority. This may require making serious sacrifices, but it is better than risking your debt ballooning and, perhaps, losing your valuable assets.

- Oran A. Hall, principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com