Published in the ECHO Journal, October 2012
When an association determines that a loan will be necessary to help fund a project, often the first question asked is “what is the interest rate.” Although a good question, the interest rate is only a small part of the loan options that should be explored in order to compare bank to bank which will be the best terms for your association’s circumstances.
Here are some additional questions that will help provide a more “apples to apples” understanding of the differences and how they may impact the association’s financial condition over the course of the loan.
The following questions assume that the association is using a bank with experience in lending to HOA’s. These lenders generally accept the association’s assessment stream as collateral. If that is not the case, be sure to understand clearly what collateral will be used. Will other HOA funds be frozen? Will liens be filed by the bank against association common areas or individual unit owners?
What is the maximum number of years the bank will lend funds for your project?
- Usually, the bank will not lend funds for longer than the life of the project – in other words, a paint job generally has a 7 – 10 year life expectancy. The bank may only approve a 5 year term for a painting project.
- The bank can generally assist the association in determining a reasonable amount of time for repayment based on the size of the association, size of the project, other projects coming up in the near future and many other factors.
- How much are the loan fees and how are they calculated? Will there be additional charges – for legal review, project inspection, document preparation?
- What is the time frame for processing the loan? How long will it take from the time that the association submits all application documents until the lender approves or denies the loan? If the loan is approved, how soon will loan agreements be presented for signing. When will the association have access to the loan funds?
How will the loan be funded?
- Will there be a draw period? If so, how will draw requests be handled?
- It is common for an HOA loan to be set up so the association borrows what is needed to pay the vendors as the project progresses. Interest is charged monthly only on the amount borrowed during this “draw period”. A project completion, the amount borrowed becomes a term loan and principal and interest payments will begin.
- Is the interest rate fixed or variable? If variable, what are the conditions for rate changes?
- Can the loan be amortized over a longer period with a balloon payment after a set amount of time? The loan would then be refinanced, or it is possible that the balance would be low enough that the association could simply pay it off. This may be the case if homeowners have paid their special assessment early.
- Are there any prepayment penalties at any time during the course of the loan? If so, under what circumstances and how are they calculated? Prepayment penalties can quickly offset a savings in interest rates.
- Can the association make additional payments to principal without penalty and will the loan be reamortized to reflect the lower balance? This is important if the loan payments are funded through a special assessment. It is common for unit owners to pay their special assessments early, often because they have sold or refinanced their unit. Those funds received by the association should be applied toward the principal loan balance. The cash flow stream from the special assessment will be reduced through prepayments. Accordingly, the loan should be reamortized after the principal reductions from the prepayments in order to keep the special assessment cash flow stream and loan payment amounts in sync.
- Is there a requirement to keep the association’s funds in the lending bank? Are there ongoing requirements during the course of the loan? Annual financials, budget, and evidence of insurance renewals are frequently required.
- Will the loan servicing remain with the bank’s HOA department? If not, how easy will it be to get answers about the status of the loan?
- What is the interest rate? Why is this on the bottom of the list? Small changes in the interest rate do not have much impact on the monthly payment. For example, if the association has a 7 year – $500,000 loan, each .25% change in the rate only increases the monthly payment by about $60. The answers to many of the questions above will have a much greater impact on the association’s bottom line.
There are many aspects of an association loan to consider. Even if your first question remains “what is the interest rate”, there is not a single answer. Most banks do not offer one rate for all loans. Rates are often higher for longer repayment periods or smaller dollar amount loans. Shorter repayment periods have both lower interest rates and lower amount of total interest paid. Therefore, it is better not to automatically choose the lowest payment amount. But rather, it is better to choose an affordable payment amount that may have a shorter repayment period in order to maximize the benefit of a lower interest rate and reduce total interest cost.
Once you are comfortable with the bank you have chosen, it will be a good time to have the banker review several scenarios to determine the best terms for your individual association.
Geri Kennedy is Vice President of Focus Business Bank. She has been a member of the ECHO Board of Directors, continues to serve on the ECHO Legislative Committee and several Resource Panels, and is a frequent speaker and contributor to ECHO events. She was elected the ECHO Volunteer of the Year in 2002.