Competition for quality (and sometimes not so quality) loans is intense and banks are looking for every possible advantage. One area where community banks can gain a competitive advantage is strategically setting amortization and call terms on loans. Specifically, there is much-heated discussion at loan committees on setting amortization periods and commitment terms on secured real estate loans. Increase amortization and you increase the principal at risk. However, you also increase the debt service coverage helping lower the probability of default. In this article, we will look at the difference of risk when changing amortizations and will provide a calculator allowing bankers to compare various amortization, commitment terms and starting loan-to-values (LTVs) to gain insight into what factors can serve to reduce risk and what factors can maximize return on term loans.

**How to Set Amortization Periods**

We have written previously about choosing the right amortization term for specific loans and collateral. We continue to see banks move further out on amortization periods for secured real estate term loans. Many banks will structure credit on 25-year amortization periods, and some banks and many insurance companies will structure 30-year amortization periods. However, other bankers are resisting this trend in higher amortization terms.

We analyzed hundreds of loans and compared the following parameters: amortization terms, balloon terms, average loan lives, and fixed rates. We then assessed the impact of these terms on loan profitability and overall risk. We ran our amortization calculator (image is shown below) to determine how best to structure term loans to increase profitability and minimize risk. This calculator is available to readers without charge.

**Analysis**

In running our loan pricing model and the amortization calculator we note the following:

**Cash flow is king:** The biggest predictor of loan performance (or repayment capacity) is the quality of future cash flow supporting the credit. The stability of cash flow far outweighs any other credit variable such as starting LTV and scheduled principal repayment.

**Call term:** The balloon period (or call term) is an important determinant of loan performance, but in special cases, where the loan is secured by long-term assets and where the loan is amortizing (which is the case in virtually all CRE financing), the balloon period is not a strong determinant of loss given default and, therefore, repayment capacity. For example, our calculator demonstrates that on a 20 year amortizing loan with an initial LTV of 75%, after 5 years (assuming no change in the value of collateral) the remaining LTV is 62% (still a meaning amount of leverage). However, when considering the same loan after 10 years the LTV is 45% - a substantially lower amount of leverage. While some bankers resist extending commitments beyond 10 years, the amount of leverage after the first 10 year period makes the loan much less risky in subsequent years. There may be very good reasons not to extend loan commitments beyond certain periods, but bankers should quantify the risks that they are trying to protect.

**Average life: **A useful and simple measure of loan exposure tied to term is called average life. Average life is a mathematical mean of the principal outstanding on the loan considering amortization period and call term. Our calculator measures average life for any loan amortization term and balloon period. Short amortization periods that are typically used for equipment financing (10, 7 and 5 year periods) dramatically diminish the average life of a loan. For example, the average life of a 25 due 5, and a 9 due 9 loans are almost identical.

**Expected life:** While contractual amortization is important and should be measured for every loan, for greater analysis bankers should also measure the expected voluntary additional prepayments. This allows correct pricing and ALM consideration.

**Mortgage style:** Mortgage style amortization is a tricky mathematical formula. Under mortgage style amortization, very little of the loan is amortized initially and substantial amounts are amortized near the end of the loan. The vast amount of principal reduction never occurs because lenders set balloons before the pivotal point in the loan amortization schedule. Further, the mathematical difference in amortization is less significant between longer amortization terms than shorter amortization terms. For example the first graph below shows the amortization curve on two loans – one structured as a 10 due 10 and the other as a 15 due 10 - the difference in credit risk on the two loans is substantially as shown by the gap between the two lines. The second graph shows the amortization curve on two loans structured as 20 due 10 and 25 due 10 – the delta between the LTV on the two structures is minimal and yet many banks spend an inordinate amount of time and energy fighting this structuring battle. In fact, the delta between 20 and 30-year amortization is also rather small. Readers are encouraged to test this in our calculator.

**Amortization Term**: Finally, the most important variables that we tested are the credit trade-offs between amortization periods and commitment periods versus starting LTV. For example, many banks would avoid a 30-year amortization for real estate secured transactions but may structure a loan as a 25 year amortizing with initial 75% LTV. Our calculator ( the graph is shown below) demonstrates that a 30-year amortizing structure with initial 68% LTV has overall lower credit exposure for the bank over the 10-year commitment than the 25 due 10 at 75% initial LTV.

**Conclusion **

When underwriting credit, we should be spending our analysis resources on variables that make the most difference in loan repayment – that is cash flow. However, we are seeing lenders make mistakes on pricing or setting amortization periods and balloon terms because the quantitative analysis and data is obscure or the math befuddling. Having the math appear clearly on a graph as shown in our calculator (HERE) may make lending decisions easier and make banks more competitive, lower the risk on loans and make the total relationship more profitable.

Submitted by Chris Nichols on August 16, 2017