2007-06-26 - Financing Options for Architecture
There are some common pitfalls that you should be aware of when considering various financing options at your disposal.  Read more on financing options...

When considering how to finance your project there are many factors to consider; the cost of the project, the credit of the investor or owner, the length of construction, if the property will be cash flow producing at any time, if the owner expects to sell the property or hold on to it, current market trends and finally expectations for the future.

There are many different types of loans and some loans can be altered to a specific project.  There are some common pitfalls that you should be aware of when considering various financing options at your disposal. 

Here are some examples of financing options are available to borrowers that are interested in using debt to finance their project.  The majority of these options are more geared towards financing residential projects:

Graduated Payment Mortgage

Graduated payment mortgage (GPM) is a type of mortgage where the monthly payments start low and slowly increase by a fixed amount each year for the first five years of the mortgage.  This type of loan is advantageous for a borrower who expects their income to grow because the monthly payments are grow.  GPMs are also great for borrowers who plan to move or refinance relatively quickly, allowing the borrower to take full advantage of the low payments early in the term of the loan.

There are several disadvantages to a graduated payment mortgage.  First of all, negative amortization is added to the principle balance due on the loan during the first part of the loan. This increases the overall cost of the loan. Secondly, the rate of a graduated payment mortgage is generally slightly higher than traditional fixed-rate mortgage loans.  Thirdly, lenders usually require a larger down payment on graduated payment mortgages.

Graduated payment mortgages are typically created to facilitate early home ownership for borrowers who expect their incomes to increase. A GPM also allows a borrower to qualify at an initial payment lower than a comparable fixed-rate loan.  As a result of qualifying for a lower payment, the borrower can obtain a larger loan and potentially purchase a higher-priced project.  The lower qualifying rate of the GPM can also help borrower in a market with rapid appreciation.

These factors, both positive and negative should be considered when deciding if a graduated payment mortgage is a wise vehicle to financing a project.

Interest Only Mortgage

An interest only mortgage requires the borrower to pay a scheduled monthly mortgage payment of interest only. Usually the option to pay interest only lasts for a predetermined amount of time between 5 and 10 years.  The borrowers have the right and option to pay more than the interest if they want to.  If the borrower only pays the interest the payment will not include any repayment of principal and the result will be that the loan balance will remain unchanged.

Experts advise that interest-only mortgages benefit borrowers who invest the money they would have paid towards the principle. They come out ahead if their investment returns exceed the rate of home appreciation.  Borrowers must be very disciplined and invest the  savings they receive from only paying interest.  If they do not earn interest on this money they are getting themselves into more debt and not utilizing the main advantage of an interest only mortgage.

Fixed Rate Mortgage

A fixed-rate mortgage charges the borrower a set rate of interest throughout the duration of the loan.  The payment made each month is the same, however the amount of that payment that goes towards paying off the interest and paying off the principle of the loan changes each month.  Because the payment remains the same budgeting is easy for the borrower.

In the beginning most of the payment goes toward paying the interest on the money borrowed.  As the loan matures more and more of the payment goes towards paying down the principle of the loan.

The main advantage of a fixed-rate loan is that the borrower is protected from sudden and potentially significant increases in monthly mortgage payments if interest rates rise. Fixed-rate mortgages are easy to understand and vary little from lender to lender. The downside to fixed-rate mortgages is that when interest rates are high, qualifying for a loan is more difficult because the payments are less affordable.
 
When considering a fixed-rate mortgage it is important to remember that although the rate of interest is fixed, the total amount of interest paid is completely dependent on the duration of the loan.  Traditionally lending institutions offer fixed-rate mortgages for varied amounts of time, most commonly 30, 20, and 15 years.

The 30-year mortgage is the most popular choice because it offers the lowest monthly payment.  However, the trade-off for that lower payment is significantly higher overall cost because the extra decade or so in the term is devoted primarily to paying interest. The payments for shorter-term mortgages are higher so that the principal is repaid over a shorter amount of time. The interest rate for shorter term mortgages is often lower, which allows for a larger amount of the principal to be repaid with each mortgage payment.  The lower interest rate can be offered for shorter-term mortgage because the lender assumes less risk in locking in a interest rate.  The lender assumes a great risk in a longer term loan.  So shorter-term mortgages cost significantly less overall.

Negative Amortization Mortgage

With a negative amortization mortgage the interest rate resets and changes during the coarse of the loan but the mortgage payment remains the same.  This means that the difference between the payment and amount owed is added to the principle.  With a growing principle and increasing interest rate the amount due at the end of the loan will quickly escalate.  These loans can be dangerous for borrowers because at some point there will be a large payment due.  They can end up being more expensive than other types of loans with growing payments especially if the interest rates are increasing.

Balloon Payment Mortgage

Balloon payment mortgages do not fully amortize over the term of the loan.  Therefore, at maturity a large amount of the principle is due.  This type of loan is conducive to real estate because land typically appreciates and the borrower can sell or refinance the property when the balloon payment is due.  Balloon payment mortgages are more common in commercial real estate than in residential real estate.

The risk to a balloon payment mortgage is that a large payment is due at the end of the loan.  For borrowers who have a large amount of uncertainty about the future and are not proficient at saving and preparing for a large payment, a balloon payment mortgage would most likely not be the best decision.

ARMs- Adjustable Rate Mortgages
 
An adjustable rate mortgage (ARM) is also known as a variable rate mortgage or a floating rate mortgage.  It is a mortgage where the interest rate is adjusted during the term of the loan based on an idex.  This type of loan transfers some of the interest rate risk from the lender to the borrower.  The increased interest rate risk taken on by the borrower means that the borrowers payment may change over time, they may get smaller but most likely, they will get larger.  The payments will decrease or increase depending on the state of the market and its affect on the chosen index. 

There are six common indices that are used in the United States.  They are the 11th Distric Cost of Funds Index (COFI), the London Interbank Offered Rate (LIBOR), the 12-month Treasury Average Index (MTA), the Constant Maturity Treasury (CMT), the National Average Contract Mortgage Rate, and the Bank Bill Swap Rate (BBSW).

When considering an ARM loan the possibility of an increased interest rate and therefore increased payments should raise some questions.  The borrower should consider how long they plan on being in the building, will they be able to cover higher payments if the rate increases, and how much they will save with an ARM loan.

Hybrid ARMs

A hyprid ARM is fixed for an initial amount of time and then adjusts with the specified index thereafter for the length of the loan. The “hybrid” refers to the combination of a fixed and adjustable rate loan. The date the ARM shifts from a fixed-rate payment schedule to an adjusting payment schedule is known as the reset date.

The risks to this loan are similar to those of purely adjustable rate mortgage.  The owner has more security in this type of loan because there is a longer period of time where the rate is fixed.  Additionally this fixed rate is usually considerably low, which is great for the borrower initally. The borrowe must be aware that the payments will most likely get larger after the reset date.

Option ARM

Option ARM loans give the borrower the option to make a specified payment, an interest-only payment, or a 15-year or 30-year fixed rate payment in any given month.

The major risk with this type of ARM loan is called “payment shock” because borrowers are allowed to let the loan amortize negatively.  This means that the borrower can make a payment that does not cover the interest for the month, so the principle grows.  “Payment shock” occurs when the negative amortization reaches a maximum, at which point the minimum payment is raised to a level that amortizes the loan balance.

In other words, when the loan reaches a stated maximum of 110% or 125% depending on the terms, this will cause a “payment shock” also called a “recast cap”.

The advantage to these type of loans is that investors can make minimum payments over the course of a year, and defer the majority of the income requried to service their mortgage debt to the end of the year, allowing income brought in as a long term capital gain, and taxable at a favorable rate, to be used in making lump sum interest payments.

These types of loans are very attractive to high net worth idividuals and real estate investors who have a long history of utilizing the negative amortization characteristics of thsese mortages to their advantage to avoid taxation entirely on gaines in real estate by refinancing regularly to “take profits” from illiquid residential and commericial real estate equity.

Asset Based Financing

Asset based financing is a general term that defines when the assets of a borrower are used as collateral for a loan.  It has become increasingly popular as a means of financing growth and providing working capital for borrowers. Most asset based loans are financed against accounts receivable and against inventory since receivables, which are among the most liquid of a company's assets followed by inventory. Receivables are favored by lenders since they self-liquidate in a short period of time and are not susceptible to problems such as shrinkage or physical damage. Another type of asset based lending rapidly gaining popularity is factoring. Factoring is defined as the purchasing of a company's accounts receivable on a non-recourse basis.

Asset based lending may be the best source of working capital for companies in turn-around where traditional bank loans may not be available or for new and rapidly growing companies where high levels of growth cause the business cycle to outpace the collection of receivables.

Long Term Debt

Most long term debt takes on the form of a loan where the interest and part of the principal are paid back in equal installments over the life of the loan. Some of the sources for business loans include the following:
· commercial banks
· government sponsored loan programs
· small business investment companies
· private lenders

Lines of Credit

A line of credit is designed to provide short term funds to a company in order to maintain a positive cash flow. Then, as funds are generated later in the business cycle, the loan is repaid. Most commercial banks offer a revolving line of credit, where a fixed amount is available. As funds are used, the "credit line" is reduced and when payments are made, the line is replenished. One advantage of a line of credit is that the no interest is accrued until the funds are withdrawn, but the line is immediately available for the company's cash flow needs.

Letters of Credit

A letter of credit is a guarantee from a bank that a specific obligation will be honored by the bank if the borrower fails to pay. Letters of credit can be useful when dealing with new vendors who may not be assured of a company's credit worthiness. The bank would then offer a letter of credit as an assurance to the vendor of payment. Although no funds are paid by the bank, the credit requirements for a line of credit and a letter of credit are similar.