Is There A True No Cost Loan?…Part One

I have heard the debate now for well over a decade. With one side nearly claiming fraud and the other side proclaiming “It’s the next best thing since twin turbo Porsches”, who’s right? Well, I am pleased to say the answer lies somewhere in between……… but definitely favoring the Porsche side of the debate. Here’s why.

In the 1980’s, I owned a number of apartment complexes. At the time, my modus operandi was to purchase a complex that could benefit from a complete renovation. This, of course, required a substantial amount of cash, some for the down payment and some for the renovation. With the completion of renovations, I typically chose to refinance the complexes to recover the cash spent during the renovation.

During this time period, it was quite common for the lenders making apartment loans to charge one to two points for these loans. While this was quite common for them, it was quite uncomfortable for me. You see, one to two points on a two million dollar loan represents $20,000 to $40,000. Ouch, those points would hurt! What made matters even worse was the fact that I knew that the loan would be refinanced with the completion of the renovations…..bigger ouch! What to do?

Well at the time, the typical apartment loan had an adjustable rate interest rate feature that determined the current interest rate by adding a margin percentage to an index percentage…..much like adjustable rates as we know them today:

While a loan with the above margin of 2.625% might cost one point, a lender would graciously offer a lower margin, say 2.500%, and charge two points. To put this into perspective, assuming a loan amount of $2,000,000, the rate and points would appear as follows:

Oh, those sneaky little devils on the loan committee.

LOAN COMMITTEE

“ Let’s give the borrower a lower rate, but let’s make them pay dearly for it. If they pay us two points and we only lower the rate by .125%, our yield will increase. Oh, we’re good!”

Understanding that those little devils on the loan committee were so yield-conscious, I approached them with a proposal. How about increasing the margin on my loan and eliminating the points and other fees? After a bit of deliberation and debate, they concluded they loved the idea. Their response to my proposal came back in the form of another interest rate option. The new option was a margin of 2.875% with no points, but I still had to pay the other related fees.

Now their rate and point options looked like this:

This added option made my decision very easy. Knowing that I would have this loan no more than one year, I converted these options into dollars. Now their options looked like this:

In this situation, by opting for the higher interest rate, I would save either $15,000 or $32,500 over the lower interest rate options. Wait a second. Maybe I ought to try saying that again… “In this situation, by opting for the higher interest rate, I would save either $15,000 or $32,500 over the lower interest rate options.”

“ME”

“Maybe, just maybe, in this situation I might be better off opting for the higher rate.”

While I was unsuccessful in convincing those bright little devils on the loan committee that they could further increase their projected yield by increasing the margin and, therefore, the rate a bit more if they would only absorb those bothersome closing costs, the seeds were planted.

Interesting concept so far. Give it a little thought and if you wish to see what happened next, click Part Two.

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