Let’s say you want to refinance a loan for a borrower that is at another bank and the loan has a prepayment penalty on it. The borrower has two options: 1) Refinance today and pay the penalty, or 2) Let the loan mature and then refinance at the then prevailing rate. We have tried all different methods and the way best to frame this problem is to present the solution in the following manner:
If the borrower chooses Option 1, then that is the same of taking that penalty, adding it to today’s rate and getting a new “blended” rate. For example, let’s say it is a $2mm loan with a fixed 6% rate, a 2% penalty and it has 1.5 years remaining. The cost of that penalty is simplistically the value of $2mm x 2%, or roughly $40,000. If you amortize that penalty over a new 10-year loan, that is another 20bp of costs.
So here is the simple decision to present to your borrower: In the next three years, do you think rates will go up faster than 20bp? If no, then you stick with the current loan. If yes, then it is better to pay the penalty and refinance.
The Solution - The Idea That Can Pop Your Next Interest Income Graph
Of course, for the most accurate answer to the above question, we can look at the forward curve. If you wanted to utilize our ARC Hedge Program, you could make the above 10-year / 25 amortizing loan for $3mm at a 5.14% rate today and we would pay you Libor + 2.50% (as we keep the hedge on our balance sheet). Alternatively, if the borrower wanted to wait and not pay the penalty, that same loan structure, 1.5 years in the future, would most likely be a 5.68% rate today, or 54bp higher.
Thus, if the borrower believes the forward curve, or does not have an opinion, then it is better to refinance today and get the lower 10-year rate, as his effective rate would be 5.14% plus the 20bp per year cost, or 5.34% effective rate.
Now there are some nuances to be aware of. If the borrower doesn’t have a prepayment penalty or has something lower than the 2% in our example, then it is a no brainer, as you just refinance now. If the borrower has cash flow or tax consideration and does not want to bear the cost of the prepay penalty now, then utilizing our ARC Program you can build the $40k into the new loan, so the borrower’s effective AND actual rate is approximately 5.34% (there is some adjustment for the time value of money, but it is slight). If the borrower does not have a prepay penalty and your bank can refinance the loan at a rate higher than the 5.14%, then CenterState Bank will pay your bank the present value difference. This is always good for banks that want to show a steady stream of current earnings.
Finally, the other important aspect is how to work with property appreciation. As property appreciates in value, lower credit risk usually follows and credit spreads are tighter. As a result, even at the same interest rate level, a loan may be in refinance territory as what was a 1.20x debt service coverage loan at Libor + 2.90% has moved to a 1.42x debt service coverage loan at Libor + 1.95%. Loans with improving credit quality present the largest opportunity for community banks to refinance from other banks, insurance companies, finance companies and securitizations.
After looking at more than $70B of existing loans out in the marketplace, our data indicates that on average almost 12% of loans in the marketplace are available to be refinanced no matter what the year. However, there are other pockets worthy of marketing and sales effort. More than 75% of loans originated in 2004 and 2005 are currently in refinance territory despite prepay penalties. Loans originated in 2010 are 35% likely to be able to be refinanced. 17% of loans originated in 2011 are able to be refinanced. All that said, there are loans that are within 18 months of maturity. Not only are more than 65% of these loans able to be refinanced for the reasons cited above, but the borrower will start to actively seek alternatives. That makes these loans more than twice as likely as other loans to be refinanced early.
At CenterState, we have actively trained our lending officers how to uncover opportunities for refinancing and how to best position the bank to increase your likelihood of winning the relationship. This training is available to your bank as well, free for banks that utilize our ARC Program and for a nominal charge (to cover travel expenses) for banks that don’t. In addition, if you have not done so already, be sure to take advantage of our free rate conversion calculator so you can see fixed and floating rate options over a variety of maturity and amortization structures. This can be found here .
Going after refinance opportunities has proven a very effective method to drive loan growth. Pass this piece on to your lenders to ensure they have the latest data and approach to give your bank the best opportunity of success.
Submitted by Chris Nichols on August 05, 2014