Some key points about commercial mortgage points

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

A. The fees that you reference are typically called points, but are called many things by different lenders.

For definition purposes, points do not include reimbursement for any out-of-pocket costs for third-party services associated with processing and approving the loan. For reference purposes, one point equals one percent of the loan amount and, in general, points are used by lenders to adjust or maintain their yield on a loan. Applied to the residential home mortgage business, points — often called discount points — are more prevalent as a method to reduce (discount) the interest rate that a prospective borrower would pay without reducing the yield to the lender. For example, a conventional residential mortgage loan of $200,000 requiring a one-point fee ($2,000) would likely reduce the interest rate by approximately a quarter percent, or 25 basis points. Prepaying the $2,000 as a discount point maintains the lender’s yield, but provides the borrower with a lower interest rate. The annual interest rate, combined with the discount points, establish the annual percentage rate, which must be disclosed to a borrower for a residential mortgage loan. Discount points are used for various borrower situations, including assisting a home purchaser qualifying for a mortgage.

In general, points for commercial mortgages are charged to increase or reach the lender’s yield requirements for the loan being considered. This is mathematically accomplished by effectively reducing the contractual loan amount to the funded loan amount by the points being charged.

When a lender is pricing a commercial loan for its own portfolio or to be sold, a spread (profit) over an index is usually applied in order to arrive at the offered interest rate. Most often, the loan quote will stipulate the spread and index, but sometimes only an interest rate will be quoted.

Included with the loan quote will be a requirement for fees or points to be paid. For example, if a lender is proposing a $1.2 million contractual loan with a 1 percent origination fee ($12,000) the loan amount being funded is actually only $1.188 million. The loan terms are quoted as a five-year term with a spread of 225 basis points (2.25 percent) over the yield to maturity (assumed to be 3.75 percent) of a five-year Treasury bond. Applying the spread to the yield of 3.75 percent indicates an interest rate of 6 percent.

The loan amortization period is 25 years, but the outstanding loan balance must be paid in full at the end of the five-year term.

See the accompanying table showing the cash flows attributed to the example.

The lender funded $1.188 million at closing, received monthly principal and interest payments totaling $92,779 annually for five years, based on the $1.2 million contractual loan amount, plus $1,079,185 as the remaining loan balance at the end of the five years. The yield on the funded amount is 6.19 percent for the 6 percent interest rate being charged. The impact to the borrower is that the APR increases to 6.19 percent instead of 6 percent, as stated in the loan documents. While this 19-basis point increase is relatively minor, an approximate increase of 3 percent in relation to the 6 percent interest rate, it increases the 225-basis point spread to the lender by approximately 9 percent, enhancing the lender’s yield.

The APR will change depending on amortization, loan term and, of course, any change in the base interest rate or points/fees being charged. Many commercial lenders are quoting par (without points), loans and all commercial mortgage lenders and mortgage bankers will disclose to you the APR if requested.

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