Interested in Interest-Only Loans

Our existing underlying mortgage is coming due early next year, so we have begun talking about refinancing. We want extra money for replacement windows, new hall carpeting, and miscellaneous repairs. We also should replenish our reserve fund. These extra items, plus closing costs, will make our new loan much bigger than our old one, necessitating a substantial increase in maintenance. Several board members have suggested that our new loan be “interest-only” to minimize the increase. Our accountant is strongly opposed to such loans. What do you think?

As a general rule, I strongly recommend that boards consult all of their professional advisors before making any big decision, especially one as important as the refinancing of an underlying mortgage. And, in most cases, it makes sense to follow your advisors’ advice. However, understanding the principles behind their recommendations sometimes makes them easier to follow, and such understanding also helps you make a reasoned decision if all of your advisors don’t agree.

Refinancing an underlying mortgage is one of the most important decisions that any board can make. It affects not only the monthly maintenance of every shareholder, but also the market value of each of the apartments. So, the structure of your new loan is critical to a successful refinancing.

Apparently, your accountant feels that your new loan should include at least some amortization. Amortization is the monthly repayment of a small portion of the outstanding loan principal in addition to the monthly interest that is due. Even a minimal amount of amortization guarantees that you will repay enough of your loan by its maturity date to cover the closing costs of your next refinancing. That assures that the debt on your building will not grow over time solely because of refinancing costs. This could be one of the reasons for your accountant’s opinion.

Another reason could be that interest-only loans saddle future shareholders with the entire burden of an ever-increasing amount of debt. Some board members argue that this growth in debt is irrelevant since most underlying mortgages are never paid off but, rather, are just rolled over indefinitely. While most co-op underlying loans are rolled over, increasing debt loads eventually will force every board to increase maintenance and/or cut services by more than would have been necessary had amortization been included in each monthly payment.

Other board members suggest that increases in apartment sales prices make their building more valuable and, hence, able to carry more debt. There is some truth to that idea, but it should be remembered that (recent trends notwithstanding) market values do not always go up. The size of your underlying mortgage as a percentage of your building’s overall value will affect the pricing of any new debt. The lower the percentage, the better the interest rate on your new loan.

From a lender’s viewpoint, the value of your building is not the average sales price multiplied by the number of units in your building. Instead, it’s the somewhat hypothetical value of your building if it were converted into a rental. So, amortization acts like an insurance policy against getting priced out of the most favorable sectors of the mortgage market.

There also is a philosophical “fairness” argument in favor of amortization. Interest-only loans afford current shareholders all of the benefits of the new funds, as well as the lowest possible monthly payment. They get to ride in the new elevators, sleep under the new roof, and look out the new windows without having to pay their pro rata share of those improvements through monthly amortization.

Moreover, if they sell their unit before the new loan matures, they receive an added bonus because their sales price will reflect the perceived value of all of the improvements even though they didn’t pay for any of them. That “privilege” goes to future shareholders.

A more equitable arrangement would be to include amortization as part of every new loan so that every shareholder pays back some of the cost of each improvement. To carry this point even further, I could make a theoretical case for matching the amortization of every new loan to the average useful life of the improvements being funded by that loan. To reach that academic standard, however, would require perfect data regarding useful lives and some fairly complex calculations. The “plain vanilla” amortization offered by most lenders is a sufficient approximation.

Having said all of the above, there are situations in which an interest-only loan is the appropriate – and maybe only – solution. For example, at the time of their conversion, some buildings got stuck by their sponsor with very large loans at below-market interest rates. Replacing those loans at current market rates could place a substantial burden on shareholders, and amortization would make that burden even harder to bear. In these situations, transitioning to an amortizing loan over several refinancings may be the only feasible choice.

Alternatively, a sponsor or previous board may have postponed repairs and upkeep for many years to avoid a maintenance increase. When the repairs become critical, the current board may be forced to borrow a lot more money. Again, an interest-only loan may be the only affordable way to get the job done without creating hardship for many shareholders.

During times of very high interest rates, some boards decide to replace their maturing loans with shorter-term (three-, five-, or seven-year) interest-only mortgages, planning to refinance them with traditional, longer-term amortizing loans once interest rates decline. This strategy incurs a double dose of closing costs but might result in lower total expenses over the full time frame.

It also may be possible to structure a combination approach. Some lenders offer loans that are interest-only during a certain introductory period after which amortization kicks in for the remainder of the loan term. This structure might allow boards to obtain the additional funds that they need now at a lower monthly payment, and then gradually raise maintenance over several years to the level necessary to cover monthly amortization.

I apologize for such a long-winded response to your question. My short answer would be to discuss your situation with all of your professional advisors (your managing agent, accountant, and attorney) and, barring some special consideration, follow your accountant’s advice.