To compete effectively, community banks need to understand who their competitors are; the products and services that competitors offer; plus, how the competition is positioning and selling these products. Conducting competitor analysis allows banks to rank themselves in the industry, leverage competitive insights, discover trends and improve their product offering. Unfortunately, many community banks do not have the resources to conduct a thorough competitor analysis. We would like to share one recent pitch from a small regional bank on how they position and sell a novel prepayment provision on owner-occupied CRE term loans.
We were recently in a meeting with a borrower and a lender from a small regional bank. The lender was competing for a $1.4mm owner-occupied CRE loan. The client (husband and wife) operate an electronics manufacturing business. The lender was selling the borrower on a 15-year fully amortizing term loan, and the sticking point for the credit was the prepayment provision. We found this lender’s pitch interesting. To be more effective in competing against banks with similar products, we feel that community banks should understand this specific prepayment provision, how this bank is positioning its loan and differentiating from its competition.
First, the lender explained that the borrower can decide what portion of the 15-year term the borrower would like to fix. With the yield curve flat after three years, the borrower was favoring fixing the rate for the entire term.
Second, the lender shared a prepayment table like the one below, which shows the cost or benefit of prepayment under various interest rate movements. The table below shows the prepayment cost and benefit of 25 basis points (bps) interest rate movement over the course of the 15-year loan.
The lender explained that if rates increased by 25 bps three years into the loan, and the borrower wanted to prepay the entire loan, the borrower would receive $17,869. However, if rates decreased by 25 bps at the same point, the borrower would owe $18,230 to prepay the entire loan. The lender explained that this provision is more equitable and creates both an upside and downside to the borrower based on rate movement. The lender also showed the borrower calculations on larger interest rate movement. The lender offered to send this calculator to the borrower for further review.
Third, the lender explained how the prepayment was calculated. The downside cost to prepay is directly related to the cost savings that the borrower would gain in refinancing the loan at a lower interest rate. Stated another way, while the borrower would pay approximately $18k to prepay the loan, the borrower would save this same amount refinancing the loan with a 25 bps lower coupon for 12 years remaining. Therefore, the prepayment calculation was a point of indifference to the borrower.
Fourth, the lender immediately identified a perceived pushback from the borrowers and addressed that next. The lender pointed out that the only way this prepayment provision would hurt the borrower is if the borrower needed to prepay the loan in the future, and interest rates were lower. If the borrowers anticipated that interest rates would decline, the lender offered a better loan solution – that would be an adjustable-rate loan with the following benefits to the borrower:
An adjustable rate would have a lower initial rate than a fixed rate loan,
- If the borrower expects interest rates to decline, the payment on an adjustable rate loan would decrease saving the borrower more money over time,
- The adjustable-rate loan has to prepayment provision, and,
- If the borrower accepted the adjustable-rate structure, they could at any point in the future fix the then remaining term of the loan at the prevailing interest rates, and because the borrower expects interest rates to decrease, that fixed rate in the future would be lower than today’s rate.
Fifth, now the lender put the decision back to the borrowers. If the borrowers think that interest rates are increasing, then the 15-year fixed may be an appealing option. If the borrowers think that rates are decreasing, then the adjustable rate option may be the appropriate one.
Sixth, the lender then pointed out that the bank would permit the borrower (subject to underwriting approval) to transfer the loan to another piece of real estate collateral or even add loan balances without invoking the prepayment provision. This assignment right allows the borrowers the ability to lock in rates for future financing needs without losing the low rate obtained in 2018. This was an appealing feature for these clients given their focus on growing their business and anticipated increased future borrowing needs.
Finally, the lender pointed out that other banks may not offer the same prepayment features offered by this bank. He pointed out that other banks are subjecting term loans to a prepayment penalty calculated as a percentage of the loan balance. That declining balance prepayment provision is not symmetrical and does not allow the borrower to retain the economics of the loan – which is especially precious in a rising interest rate environment.
We found this particular pitch novel and interesting. We have heard that national and larger regional banks are offering similar prepayment provisions. Community banks should understand what their competition is offering to be better able to compete and position their products. This specific prepayment provision requires particular attention from community banks because of the consensus market view of rising interest rates.
Submitted by Chris Nichols on September 26, 2018