Profitability Implications of an Introductory Interest Only Term

Background

A LoanPricingPRO client recently asked for assistance in analyzing a commercial real estate loan with an introductory interest only period.  Specifically, their borrower was looking for a fixed rate, $2.7mm loan with interest only payments for the first 2 years and then principal and interest payments for another 5 years based on a 25 year amortization schedule.  Our client wanted to know if the pricing needed to be different compared to the same loan without the interest only period.  Let’s take a closer look.

CaseStudy1

Cost of Funding Impact

When analyzing loans for profitability, longer term loans have higher funding costs than shorter term loans.  In our example, the loan with the introductory interest only period has a fixed rate term of 84 months after accounting for the 24 month interest only period and the 60 month P&I period.  The loan without the interest only period simply has a 60 month P&I term.

CaseStudy2

The impact of these varying terms is significant.  In the funding curve above, the difference between the cost of funding the 84 month loan and the 60 month loan is 44bps (2.57% vs. 2.13%).  By agreeing to fix the rate for a longer term with the interest only period, the bank is exposed to more risk both from a liquidity and interest rate perspective.

Profitability Analysis

A quick analysis shows that a fixed loan rate of 4.47% is required over the combined 84 month interest only and fixed P&I period in order to achieve a 12% ROE.  This same loan, without the introductory interest only period, would only require a loan rate of 4.03%.

CaseStudy3

Summary

On the surface, it might seem like there is minimal difference between pricing a simple fixed rate loan and a fixed rate loan with an introductory interest only period.  But, it is important to recognize the additional risks associated with extending the fixed rate term with an interest only period.  You should be compensated for this increased risk through higher pricing.

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