Borrower fixation on headline interest rates for loan offers has always been a concern to me. In recent times it appears to be getting worse, not better.
What should really matter is the overall cost of the funding.
In progressively drawn loans, such as for residential construction, a line fee is an estimate by the lender of the cost of holding open the line of credit.
Some lenders appear to have thrown this concept out the window.
These lenders work on the premise that borrowers focus on the quoted interest rate and don’t understand the true cost of the line fee. Alternatively, they have been conditioned to higher line fees by the Banks who have long understood the multiplier effect of line fees on interest rate.
Quick comparison calculation
Interest rates should be calculated on the drawn balance of the loan. Be careful here. I have heard of loan offers which include a minimum interest earn and/or a minimum loan draw down each month. There are many other ways to pump up the effective interest rate.
As a rule, there is a 60% usage rate of funds for residential construction. I base this on the GPS S-Curve which has been developed and maintained for over 25 years. I note that no two loans will be the same. It comes down to the amount of each progress draw.
On this basis, and keeping the numbers simple, an interest estimate for a $10m, 12-month term construction loan should be calculated on 60% of the loan amount namely, $6m. If the interest rate is 5% the interest estimate would be $300k.
Line fees are calculated on the loan amount. On the above example, a line fee of 3% would be $300k.
If you add the estimate of the interest to the estimate of the line fee the overall cost estimate would be $600K or an effective interest estimate of 6% on loan amount.
This shows that a 3% line fee can have a cost of close to a 5% interest rate on a comparison basis.
My rough calculation, for comparison purposes, is to divide the line fee by 0.6% and then add on the interest rate:
( line fee ÷ 0.6 ) + interest rate = overall rate
If the quoted interest rate is 6.95% and the line fee is 1% then the formula is:
( 1 ÷ 0.6 ) + 6.95 = 8.62%
In comparison, if the quoted interest rate is 4% but the line fee is 2.75% then the formula is:
( 2.75 ÷ 0.6 ) + 4 = 8.58%
They are roughly the same.
I have used the above numbers as they come directly from a recent conversation. GPS was quoting for a bank quality deal at a 6.95% interest rate with a 1% line fee. The reply was along the lines of “why borrow from GPS at a 6.95% interest rate when they can get it at a 4% interest rate”. I enquired as to the line fee which they said was 2.75%. There was disbelief when I said they are about the same cost and that, in such a circumstance, GPS should be the choice as we offer better levels of service.
I note that as each project is different you will need to perform a more detailed calculation, which is specific to each project, to work out the real cost estimate.
My above calculations are, literally, my rule of thumb.
By way of product update, GPS is now facilitating a conversion of loans over to a residual stock facility once titles and the first round of settlements have been achieved. As the loan is then a different class of asset, we are not charging a line fee. This can represent a considerable saving to borrowers. As line fees are calculated on loan amount they can really bite during later stages of a sell down of a project.
Sounds interesting? Give us a call to discuss further:
Monica De Nino | GPS Head of Lending – 1800 999 109
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[…] We’ve previously talked about the real cost of line fees, and the best way to calculate them, here on our blog. […]