Sometimes how we choose to measure something can lead to incorrect conclusions. While mathematically 30 is 50% more than 20, a 30-year amortizing loan is not 50% riskier, or 50% longer than a 20-year amortizing loan. The amortization term is often a poor measure for bankers to use to make credit decisions. In this blog, we will explain why the amortization term can be a misleading measure, why bankers should be using average life, and we will provide readers with a downloadable average life excel calculator for bankers to use for their own analysis.
While the amortization term does measure the time for a loan to reach a zero principal balance, there are two critical factors that can mislead bankers who measure amortization terms. First, most loans are amortized on a mortgage-style calculation, making the initial period principal reduction small compared to later period reductions. Therefore, the principal outstanding during loan commitment terms of five years or less have similar principal outstanding for different amortization terms. Second, for bullet or balloon loans (a majority of commercial loans) the amortization period has little impact on overall principal outstanding, and it is the commitment term (not amortization term) that primarily drives average principal outstanding.
The graph below shows the loan-to-value (LTV) remaining on three loans that all start at 75% LTV but follow a 20, 25 and 30-year amortization period. During the first few years, the principal balances decline at similar levels for all three loans. It is not until much further out on the timeline of the loan that the differences in principal outstanding become substantial. However, as time passes, the principal reduction becomes more meaningful for all three loans, and exposure and loss-given-default become more acceptable even for the 30-year amortization schedule. In other words, time magnifies the difference in the three amortization schedules, but at that point, all three loans demonstrate substantial deleveraging.
Average life is the length of time the principal on a loan is expected to be outstanding. The calculation takes the date of each expected future principal payment and divides by the total starting loan amount. This measure is sometimes called weighted average life. Unlike bond duration, the average life measure is simple to understand and also measures the term of the principal outstanding, thereby giving bankers a correct measure of the interplay between principal and time. For loans with no amortization (IO loans), the commitment term will equal the average life.
In the graph below, we show mortgage-style amortization terms from 10 to 50 years and the calculated average life of those loans with a five and 10-year commitment term. For the five-year commitment term, the loan’s average life is almost identical from 20 to 50-year amortization periods. For the 10-year commitment term, the loan’s average life for 20-year amortization is 8.28 years, and the loan’s average life for 30-year amortization is 9.15. For a 10-year commitment, the difference between a 20-year and 30-year amortization is only 10.5% more average life, and not 50% more as the amortization terms may incorrectly imply. For a five-year commitment, the difference between a 20 and 30-year amortization is only 4.3% more average life.
Amortization, POD and LGD
One other aspect of amortization is that when you extend out amortization, you create more free cash flow for the project or company thereby decreasing your probability of default (POD). Less debt service means the company can deploy cash flow to other obligations. A company or project with front-loaded liabilities may often be better served by a longer amortization period.
Of course, by increasing your amortization you also increase your exposure at default and hence your loss given default. Thus, extending amortization is a trade-off of risks. Since most of a commercial loan’s risk is driven by the probability of default, in stable economic times, your net risk can often decrease by extending amortization and increase debt service coverage.
Conversely, for riskier credits or in times of a credit shock, a longer amortization will be negligible on cash flow but materially increase the loss given default in such a manner that net risk is increased. Our point is to know the quality of the borrower’s cash flow and use that as a data point to make your determination of the amortization period. The higher the quality of cash flow, the more willing a bank should be to extend amortization.
Between all of the credit parameters that banks can control such as cash flow, starting leverage, credit support, covenants, springing liens, cash flow sweeps, and others, the amortization period may be one of the less important determinants of safe and sound underwriting. Bankers should not be fooled by a misleading credit measure like amortization periods. It may seem intuitive but can be highly misleading when pulling together all of the structured components of a loan. Bankers can download our simple excel file to calculate average life for any common loan structure by clicking HERE.
Submitted by Chris Nichols on July 15, 2019