Setting payments on variable-rate term loans in an environment of rising interest rates

RMA Journal, The, April, 2005 by Richard A. Hamm

This article offers community bankers some simple loan-pricing approaches that minimize profit-margin erosion during periods of rising interest rates. These approaches can be used at the lender level for smaller loans not eligible for the formal hedging techniques used on larger loans and at the top of the bank.

Bankers anticipating an environment of rising interest rates know that floating- or variable-rate loans are a good hedge to interest-rate risk. This is particularly true for smaller loans (under $2 million) where it's not practical or cost-effective to employ hedging techniques, such as interest rate swaps or caps. However, borrowers whose loan repayments will take more than a year generally prefer fixed interest rates, and they want to lock in rates while both short- and long-term interest rates remain low.

Given these competing goals, bankers face three loan structuring and negotiating issues for term loans:

1. Creating incentives for customers to select a variable rate.

2. Setting a monthly payment that prevents negative amortization.

3. Monitoring the loan in the future.

The Current Environment

For community banks, the dominant index used for variable rates is the prime rate. While some banks call it the base rate or index rate, the index is very close to the "New York prime" set by moneycenter banks, which is further tied to the federal funds rate.

Increase expected. During 2004, the federal funds rate increased 125 basis points (1.25%), while longer-term rates (such as the 10-year U.S. Treasury note) were relatively stable. For 2005, economists expect short-term rates like the federal funds rate to increase at least another 125 bps.

Negative amortization. A term loan structured with periodic (usually monthly) payments of principal and interest may be subject to negative amortization, a situation in which the monthly payment is not sufficient to cover the interest due and there is no principal amortization. This can happen if interest rates increase during the life of a variable-rate loan after the monthly payment of principal and interest (or a mortgage amortization where the payment is applied first to interest due, then the remainder to principal) was set at the rate existing at closing.

Creating Incentives

When a term-loan customer selects a variable rate instead of a fixed rate, the customer, not the bank, takes on interest rate risk. It makes sense, then, to offer an economic incentive.

* Lower origination fee on the variable-rate option. This is perhaps the most basic approach and gives the customer an immediate, tangible benefit. As a practical matter, the difference in origination fees can be fairly small, often 0.25% to 0.50%.

* Longer loan maturity and/or repayment schedule on the variable-rate option. Rather than an immediate lower loan cost, the customer receives a short-term cash flow savings with an extended payment schedule. Again, as a practical matter, an extended schedule of as few as an additional 12 months can be an attractive incentive to the customer.

* A one-time option to convert the variable rate to a fixed rate. If a customer strongly desires protection against a large increase in interest rates, a conversion option may be more desirable than the other incentives. With minimal notice of about 10 days, a customer can elect to convert the interest rate from variable rate to fixed. A few guidelines for setting this option are 1) the loan must not otherwise be in default; 2) the fixed rate is a pre-set spread over a common index, such as the LIBOR (London Interbank Offered Rate) swap curve or the constant-maturity U.S. Treasury note; and 3) the index must closely match the remaining period to the original maturity date of the loan (for example, if two years remain until loan maturity, a two-year index is used; the payment is recalculated and remains fixed for the remainder of the loan term).

Three Ways to Set Term Loan Payment

If the lender is successful in negotiating a variable rate, there are three ways to structure the loan payment to avoid negative amortization. Obviously, if the bank's loan accounting system can adjust the loan payment monthly, it's easy to avoid negative amortization. However, many customers--for budgeting and cash flow planning reasons--prefer term loan payments that vary less frequently. Here are three approaches to use in this situation:

1. Keep a fixed payment, but base it on a higher, fixed-equivalent rate. Perhaps the best option for loans that fully amortize over three or five years is to offer a fixed monthly payment of principal and interest, but calculate the payment based on a higher interest rate than the actual rate in effect at closing. Use, for example, an interest rate equal to the fixed rate offered (or could have been offered) the customer based on the proposed maturity. This fixed rate approximates the expected average of the variable rate over the time period of the loan and is a fair way to set the loan payment. Early in the life of the loan, excess funds are applied to the principal so that higher interest amounts due can be covered later in the loan if rates increase.