A few months ago, we had a borrower ask a brilliant question. "Have we been making the correct financing decisions historically, or can we do better?" In other words, that borrower was out to understand how their decisions around financing affected their portfolio, and (as they would discover) how much might they have saved by making a different decision.
We know they are not the only ones asking this question, so we want to empower those dedicated to constant improvement to take the same steps of evaluation. In this release, we are breaking down the first steps to quantify whether your financing decisions were the best ones to make, and giving you the tools you need to better evaluate future decisions.
In the end? We'll arrive at a "New Deal Checklist" that will contain all the questions you should be asking yourself before acquiring a new loan, and maybe you can save millions too.
Term Mismatch (or: the Hidden Cost of Debt)
Here's the first question you should ask yourself: How often do you hold loans to full maturity?
We know the answer is almost never, but here's the follow up kicker: How often do you pay off well ahead of maturity?
It becomes tough to evaluate this with limited bandwidth, already having to constantly analyze upcoming sell/refi/hold decisions, but when you start to line up your history of maturity date vs payoff date, you might be surprised by what you find.
Term Mismatch: Case Study
In the case of the borrower we mentioned at the top, we compared the loan term vs hold term for 33 of their loans. Here's what we found:
But what does this mean in dollars? Let's quantify.
Term Mismatch = Term Premium
Locking in fixed for longer usually feels safer, but that perceived security comes at a cost. Longer terms generally come with higher interest rates. That higher interest rate usually comes in two different forms:
1. Yield Curve - longer term rates are generally higher than shorter term rates. For example, a 10 year fixed rate is usually higher than a 5 year fixed rate.
2. Spread - lenders will commonly charge more for longer terms.
To quantify the inefficiency from that mismatch, we need to see where rates were on the day of closing.
Example: Let's say a $27mm loan closed on 10/1/2013. This 10 year loan was paid off 56 months prior to maturity, which means the borrower would have been better off choosing a 5 year loan.
Yield Curve
Let's examine the premium between the 5 year Treasury and the 10 year Treasury on the day of closing.
On 10/1/13, the 5 year Treasury was 1.43% and the 10 year Treasury was 2.65%. The premium is 1.22%.
With the benefit of hindsight, the borrower could have saved 1.22% per year over five years.
On this $27mm loan, that's $1.65mm.
Spread
But they also paid a higher borrowing spread for choosing 10 years rather than 5 years. By examining their options at that time, they concluded that they overpaid by 0.15% (5 year spread = 2.15% and 10 year spread = 2.30%).
Over five years, that translated into an additional $202,500 of interest expense.
Overall
Looking back, had this borrower chosen a 5 year loan instead of a 10 year loan, they could have saved 1.37% per year, or over $1.85mm.
Pro tip - this matters less today with such a flat yield curve, but it's good to quantify this difference. Develop the muscle memory now while there's less at risk.
Check out our New Deal Checklist here.
Read Part 2 of our breakdown! Or download our eBook for the full story.