Some key points about commercial loan points

Q. Can you explain the interest rate implications of a commercial mortgage loan that has an application, origination or processing fee required by the lender?

A. Such fees are typically called points, but are named many things by different lenders. They don’t include reimbursement for any out-of-pocket costs for third-party services associated with processing and approving the loan.

For reference purposes, 1 point equals 1 percent of the loan amount. In general, points are used by lenders to adjust their yield and the borrower’s annual cost of the loan.

In the residential home mortgage business, points (sometimes called “discount points”) are more prevalent as a method to reduce (buy down) the interest rate that a prospective borrower would pay. There are numerous residential loan programs with many variations, which can impact the interest rate. These loan programs are established by the investors that purchase the loans from the residential mortgage broker and are used for all situations, including differing credit scores and assisting a home purchaser to qualify for a mortgage by reducing the monthly payment. When a residential loan program is offered to a borrower, the annual percentage rate cost for the borrower is a required disclosure.

Typically, points for commercial mortgages are charged to increase or achieve the lender’s yield requirements. This is mathematically accomplished by effectively reducing the amount of funds loaned by the amount of the points being charged.

When the lender is pricing the loan, a spread over an index is usually applied in order to arrive at the interest rate. Most often, the loan quote from a lender will stipulate the spread and index, but sometimes only an interest rate will be quoted. Along with the terms being quoted there may be a requirement for fees or points to be paid.

For example if a lender is providing a $1.2 million loan with a 1 percent origination fee ($12,000), the funds being lent are actually only $1,188,000. The loan is quoted as a five-year term with a spread of 225 basis points (2.25 percent) over the yield to maturity of a five-year Treasury bond.

Applying the spread to the Treasury bond yield of 3.75 percent indicates an interest rate of 6 percent. The offered amortization period is 25 years, but the outstanding loan balance must be paid at the end of the five-year term.

The accompanying table shows the cash flows attributed to this loan.

The lender will fund only $1,188,000 and receive monthly principal and interest payments totaling $92,779 annually for five years. The principal and interest payments are based on the $1.2 million face amount of the loan with a 6 percent interest rate and a 30-year amortization. In Year 5 at loan maturity, $1,079,185 will be the outstanding balance. The yield on the loan is calculated to be 6.19 percent instead of the 6 percent interest rate being charged.

The impact to the borrower is that he or she is paying interest at the annual percentage rate of 6.19 percent instead of 6 percent. While this 19-basis point increase is relatively minor in relation to the 6 percent interest rate, it is an approximate 9 percent increase in the 225-basis point spread that the lender quoted. The annual percentage rate will change depending on amortization, loan term and, of course, any change in the base interest rate or points/fees being charged.

For example, a one-year construction loan with a 1 percent fee on the full loan amount increases the lender’s yield dramatically because the full loan amount is not initially funded and is often times not ever fully drawn.

Most lenders will quote par (no-point) loans, and all lenders, if asked to, will calculate and disclose to you the annual percentage rate if requested for fixed rate term loans.

David B. Eaton, president of Eaton Partners, Manchester, manages the firm’s Commercial Mortgage Group. Questions can be submitted to him at Commercialnotes@eatonpartners.com.