Level Principal Pay as an Alternative to Standard Amortization

August 31, 2016 Joel Rosenberg

 

The best relationship managers take an approach to pricing that gives the customer options and makes them feel heard. It’s about turning a deal into a conversation and finding solutions that benefit both bank and borrower. Often that means offering something different than “the way we always do things.”

Case in point? Sometimes it makes sense to go away from an old standby like the standard amortizing loan and instead offer a level principal pay loan.

We’ll explain a bit about each structure and go into the pros and cons of both below.

Standard Amortizing Loan

Many commercial loans (excluding lines of credit, interest-only loans and construction lending) have an amortizing feature. This generally means the monthly payment (P&I) remains constant and the portion applied to principal increases while the interest component declines (standard amortization method).

The graph below displays a 120-month fully amortizing loan:

Amortizing Loan 120 Months

Level Principal Pay Loan

In a level principal loan, the principal payment remains constant, while the interest portion is reduced over the term of the loan. It results in a total payment that declines over time.

The principal portion as a percentage of the total payment is initially greater than the standard amortization method, but over time they equalize. Also, in terms of monthly paydown, the level principal amount is larger initially, but eventually the principal payment under the standard amortization method exceeds it. See the chart below:

Level Principal Pay

Assuming the same loan terms, the total payment is initially 18% larger for the level principal alternative, matches at about 55 months and is 21% lower at maturity in ten years.  Thus, the level principal pays down the loan quicker.

Amortization & Level Principle Payments

Level Principle Pay Pluses for Bank & Borrower

Using the level principal payment approach can be beneficial for the borrower and the bank. Some of the advantages for the borrower include:

  1. The payment amount goes down over time and by about midway in the term of the loan the P&I would be lower than under a standard amortizing loan.
  2. The larger initial payments mean that over the life of the loan the borrower would pay less in interest. In the example above, the total interest paid under the standard amortization (assuming the loan lasts the full ten years) is $332,236, while under the level principal alternative the interest paid is $306,701, or a 7.7% reduction.
  3. If the borrower needs to sell the collateral backing the loan early, the loan lien on this collateral would be less.

Level Principal Pay Minuses for the Borrower

On the flipside, there are two main disadvantages for the borrower.

First, the initial payment amounts are greater. In the example discussed, the amount would be about $2,300 higher for the first month. For a client with some cash flow issues, this approach might not be appropriate. However, for a client with excess cash and strong profitability, this can provide a degree of safety for the future, when their payments will be lower.

The second issue is that the higher payment will affect the debt service ratio, which could lead to a lowering in the client’s risk rating. A lowering of the rating often results in a higher interest rate.

Level Principal Pay Pluses for the Bank

The bank benefits from this approach by:

  1. The more rapid initial paydown means that the loan to value ratio (LTV) will strengthen faster.
  2. The Level Principal approach results in lower interest rate risk. Using the loan already discussed, the Macaulay Duration level for the standard amortization is 55.5 months while for the Level Principal it would be 51.5 months or a 7% improvement.
  3. In a rising interest rate environment more funds come back initially.
  4. Compared to a similar maturity loan using standard amortization, the amount of equity needed to support the loan under level principal alternative would be lower, absent any minimum levels.

Level Principal Pay Minuses for the Bank

The main disadvantage for the bank is that principal is returned faster and must be reinvested.  Also as noted as a positive for the borrower but a negative for the bank, total interest collected is less under the Level Principal alternative. This can result in a lower ROE, although the reduction in equity required and reduced interest rate risk generally ameliorate this situation.

Finally, this might be a little more operationally complex, with the changing payment amount each month. However, this should be no more complicated than normal amortizing floating rate loans in a volatile interest rate environment.

Conclusion

The utility of the level principal pay loan really depends on the situation. And that’s the point. It’s another example of the merits that come when a lender develops multiple scenarios for a loan opportunity. Changing the maturity, interest rates and fees, rate type, collateral requirements … these are all options available to the lender, along with level principal pay and standard amortization.

Modelling a level principal payment loan, in addition to the standard amortization loan, can provide the borrower with another alternative that might be better in meeting their needs. And it can indicate to the lender what rate is required under this approach.

For more information on creating scenarios, you can check out this video. Also, Level Principal Payment Type is now available on Commercial Loan products for PrecisionLender clients.

 

 

The post Level Principal Pay as an Alternative to Standard Amortization appeared first on PrecisionLender.

 

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