When looking to arrange bridge financing, at least part of the borrowing decision is going to be about the cost of capital versus the benefit you are going to get for putting a bridge loan in place.
To properly understand the cost//benefit relationship of any particular deal, you have to be able to accurately estimate the potential cost of capital prior to entering into a short term financing agreement.
Failing to do this may result in a higher cost than the value of the expected benefit, which in hindsight may have caused you not to acquire a bridge loan in the first place.
Depending on the specific lender providing short term or bridge financing, there can be a number of different cost elements to add into the projected cost of capital with some being more material than others.
For instance, there can be a different fee and cost structures from one institutional lender to the next and one private lender to the next.
This can also vary for business loans versus personal loans.
And yes, we are talking about projected cost of capital due to the fact that the effective cost of financing will vary depending on what transpires during the life of the loan.
Let’s break the costs down into fixed and variable components.
The potential fixed costs for the transaction can include legal fees, appraisal fees, environmental assessment fees, lender fees, and broker fees.
All these costs can be accurately estimated before any money is actually spent, but there can be some variability between what is estimated and the final cost paid.
For instance, legal fees can be quoted for the completion of a transaction or by time. Environmental assessments can require additional work which can lead to additional costs. Lender and broker fees are usually a percentage of the money borrowed, so if the amount of money to be borrowed goes up or down, these amounts will change as well.
The variable costs would potentially be things like transaction costs and prepayment penalties.
A lender will typically provide a list of service charges for different events such as NSF payment fees, partial discharges of security, and so on.
Prepayment penalties will be clearly spelled out, but will only be incurred in the event of prepayment prior to the completion of the loan term.
If you expect to repay the loan, or will need to repay the loan prior to the end of the term, then the prepayment penalty becomes a fixed cost.
Most bridge loans are for a period of one year, especially if they are backed by real estate security.
If you assume the worst case scenario and project that most potential costs are going to be incurred including prepayment penalties, then you would divide your total costs by the amount borrowed to arrive at an effective interest rate expressed as a percentage of funds borrowed.
But as I mentioned at the outset of this article, the cost of capital in dollars is the most important thing to understand so that you can determine if the value assigned to the benefits of acquiring short term financing outweigh the costs.
The actual interest rate expressed as a loan interest rate to be charged monthly or the effective rate of financing with all costs factored in is a secondary consideration to the actual projected cost of borrowing.
So once again, determining the worst case scenario and a likely case scenario will be important when evaluating a particular financing option as well as the cost/benefit relationship of the underlying deal.
First of all, when we talk about prepayment, we are talking about paying back all or part of the principle amount of a private mortgage before the end of the interest term.
This is not an unusual occurrence with private loans due to the fact that many are bridge loans and while the standard length for an interest term is one year, the use of the money may only be for a number of months.
And when the exit strategy to repay the loan develops prior to the end of the term for the mortgage, a prepayment of funds will occur.
For a mortgage to be prepaid, the mortgage needs to be an open mortgage that allows for early repayment.
If the mortgage is closed, no prepayment can occur and fill payment will be required at the end of the mortgage term unless a renewal option exists or is extended by the lender.
When a mortgage is open, there may or may not be prepayment penalties associated with early principle repayment.
This is going to be important to understand before you sign a commitment for private funding in that an open mortgage does not automatically infer that there will be no prepayment penalty.
For many private mortgages, the prepayment penalty is going to be three months interest on the amount prepaid.
But there are many different variations to prepayment penalties or costs as well.
Some mortgages will be fully open with no penalty for any amount of principal prepayment at any time during the loan term.
Other private loans will be open with no penalty after a certain number of months have passed from the start date of the mortgage, but have a penalty in place up until that point.
The actual amount of the penalty and the way its calculated can very quite a bit, but it cannot exceed the rules governing this action which typically cannot be more than three months interest on a mortgage with a term of one year.
So when you’re looking to secure a private mortgage on a piece of real estate you now own or are in the process of acquiring, try to match your prepayment options with your needs so that you can minimize your borrowing costs in the process.
At the very least, make sure you understand the prepayment options that are provided in a mortgage commitment so there are no surprises down the road.
Because private lenders are unique individuals that make their own lending decisions in many cases, you may also be able to negotiate a prepayment option that will work for you instead of just accepting whatever is provided in a loan commitment.
That being said, if time is of the essence to get funding in place, you may not have the flexibility to negotiate or seek out a superior repayment option in the time you have to work with. In those cases, make sure you at least understand what your options are and manage you cash flow accordingly if a prepayment opportunity arises.
The new mortgage rules on federally regulated banks (80% lending on refinance, $1,000,000 cap on residential, tighter self employed qualifications and fewer cash back options) has created an environment for more creative mortgage solutions.
And in some cases this can result in a second mortgage from a non federally regulated institutional lender or from a private lender.
The hole that people are attempting to fill is the financing over 80% on some type of refinance.
With the 2012 mortgage rules now in place since July, the maximum of 80% financing down from 85% may not seem like a lot, but it can can make the difference between making the numbers work and filling up your credit cards.
There still are some institutional lenders, particularly some credit unions, that are prepared to consider second mortgage financing up to 85%, providing that added bit of capital for those that qualify.
The same is true on the private mortgage lending side where some privates may even go higher than 85% depending on the real estate involved and the strength of the borrower. That being said, privates that go above 85% loan to value are in the minority of the private lending market place and higher loan to value amounts also tend to lend to higher interest rates.
But compared to being short on the cash required and having to push money into credit cards, most private money interest rate options could still be better than your readily available short term credit like credit cards provide. And even if you were to go with a credit cards to fill the cash amount required, you’re still using up the available credit you have to work with which can cause other problems including reducing your credit score.
Short term financing vehicles like credit cards also typically require 3% of the principal balance repaid every month were most private second mortgages are interest only.
Obviously the objective with any type of mortgage lending is to minimize the cost of capital as much as possible. So while some form of institutional second is always going to be preferred, a private mortgage option may end up being significantly less than any other alternative such as credit cards.
If you are looking at a private second option, make sure you are also looking ahead to how that second will be repaid in a year’s time.
Having a plan in place to repay this type of bridge loan us going to help insure that your finances will stay in order and that you won’t have to continue on with the private money option longer than you need to.
To find out more about second mortgage options available to you, give me a call at your earliest convenience and we can go through your situation in detail.