There are many reasons why borrowers sometimes find themselves at a disadvantage after signing a commercial mortgage agreement. Sneaky loan clauses and unfavorable loan covenants are not properly understood and the lender doesn’t take the time to explain every point to the borrower. Most times, the borrower is in a hurry to get over the paperwork and access the funds being promised them. It doesn’t help that mortgage agreements are usually in the range of 10 pages of fine print. Borrowers forget that they’ll have to endure any unpleasant loan condition for the entire lifespan of the loan.
You will be saving yourself a whole lot of pain, financial loss and regret if you take the time to prepare yourself and know what to look out for before putting pen to paper.
Top 9 Loan Signing Tips
1. Loan Payment Agreement
Let’s start with the loan payment agreement. The payment terms for a commercial mortgage will usually include conditions to protect both parties to the loan. Taking your time to go through these conditions and understanding their implications will put you in a better position to assess the risk and know your potential responsibilities should you decide to go ahead with the loan.
Consider the kind of loan repayment feature being offered you. Will the loan continue with regularly scheduled payments on an amortization schedule or is it a balloon payment loan requiring you to pay a large balance at the end of the loan period?
Balloon payment loans are more common with commercial rather than individual consumer lending. They are fixed rate loans, so whether rates fall or rise, it won’t affect the agreed loan rates even over a long period of time. This could be an advantage or disadvantage to the borrower. If rates rise, you still maintain your low monthly payments but if they fall, you can’t renegotiate for lower payment terms.
Also, signing a long-term, fixed rate loan means it could cost you dearly to enjoy lower monthly payments if interest rates fall because of the inevitable loan prepayment penalty. Fortunately, there is usually a provision in commercial loans with balloon payments of a standard period of months just before the loan is due where there’s no penalty for prepayment. You should be clear on exactly how long your zero-prepay penalty period is and how much penalty if any you’ll have to pay. You can usually expect to pay about 80% of six months interest as prepayment penalty.
If for some reason you are unable to source funds to refinance your principal amount through a conventional lender, note that many alternative commercial lending options exist such as that offered by Las Vegas Funding.
2. Loan Covenants
Your commercial mortgage will include many binding covenants in addition to the financial agreement. Loan covenants are conditions imposed on you, the borrower. They are made to ensure you fulfill certain conditions and will in many cases forbid you from undertaking certain actions. They also serve as a kind of performance indicator for the lender to monitor the direction the investment is going.
These conditions can be financial, affirmative, information based and some typical restrictions include; controls on operating activity, scheduled reporting and disclosure, asset sale, investment expenditure and so on.
Covenants have the potential of becoming very negative if not properly managed. The debtor’s economic freedom could become stifled due to excessive control on the part of the lender leading to decreased efficiency.
Check all the covenants carefully before you sign. Remember that if you breach any of the conditions, the lender has the right to call the loan or demand a higher interest rate. You may also be forced to undertake certain actions in order to maintain the relationship with the lender.
3. Financial Reporting
Commercial mortgage lenders will need proof of your financial position. Expect to provide information like the current cash flow from your commercial property, your own personal financial information and financial reports from any entity with a claim to the title of the property.
They will likely ask for your balance sheet statements, submissions of tax returns, and income and expense statements. You’ll need to provide this info on a continuous basis for the lifetime of the loan at preset intervals usually quarterly, half-yearly or yearly. Take note of exactly when you are to provide these reports.
Some lenders will ask that you maintain a specified positive cash flow level or a debt-to-cash-flow ratio may be included as a condition for obtaining the loan. Presenting all this information may not be a major problem for the borrower per say, but it can become burdensome and look like an intrusion into their privacy.
4. Recourse vs Non-Recourse Covenants
In a recourse loan agreement, the borrower and guarantors are personally liable for any outstanding loan balance in addition to the collateral.
A non-recourse covenant restricts the lender to compensation in the form of only the value of the loan collateral (in this case property) in the case of default. So even if the collateral doesn’t cover the full value of the loan amount, the lender cannot pursue the borrower for further compensation.
Many borrowers prefer the non-recourse option to protect their personal assets in the case of loan default. But, they must be mindful of carve out provisions commonly known as bad boy guarantees.
A bad boy guarantee will allow the lender legally pursue the borrower in certain conditions like willful waste, fraud, committing criminal acts, not maintaining required insurance, misappropriation, bankruptcy etc.
You may want to carefully weigh your choices between recourse and non-recourse loans as each has its pros and cons.
A recourse loan, for instance, will typically offer you lower interest rates and reduced margin requirements. So if the loan request comes with a minimal loan-to-value ratio, selling the collateral in case of default will likely mean no loss on the part of the lender and there would be no need to pursue the borrower further.
5. Adjusting Rate Mortgage
This kind of commercial mortgages transfers some of the interest rate risk from the lender to the borrower. They are common when unpredictable interest rates exist and as a result, fixed rate loans are difficult to obtain.
They can be structured in many ways that will determine how expensive the loan is. You’ll need to know how often you can expect the rate to adjust and the cap per each period. There should be some margin for the maximum (ceiling) and minimum (floor) rates expected. Sometimes, the minimum rate will even fall below the initial rate at the start of the loan. As a borrower, you will benefit when the rates fall but lose if the rates increase.
6. Referencing Market Index
The Referencing market index serves as a kind of benchmark when setting the interest rate calculation for the loan. The London Interbank Offer Rate or LIBOR remains one of the most popular mortgage indices in the market. Other indices include prime, and averages from Treasury bills, financial institutions Certificates of Deposit, the Cost of Funds/ the Cost of Savings, or even swaps.
The interest rate is determined by adding a margin to the preferred index. So if you’re using the LIBOR at 2.5% margin and your mortgage index is 3%, the interest rate on the loan would be 5.5%.
The agreed index average that’s used for the loan interest rate can be calculated across different time frames like 6 months or annually. You can have a better idea of how the interest rate on your loan will fluctuate by doing a trend analysis of the historical performance of the selected index for your loan.
7. Prepayment Penalties
Many borrowers don’t understand the implications of a “prepayment penalty” or why it should even exist in the first place.
This penalty is commonly known as a “prepay,” and most lenders will as a policy add a prepayment penalty clause to their commercial loans. When the borrower chooses to pay in excess of the agreed rate within a certain timeframe, as could happen if the borrower decides to sell the house or refinance the loan, the penalty can take effect.
They come in various forms like step-downs, soft prepayment penalty, lock-out periods, yield maintenance and defeasance. You need to come clean with the borrower at the negotiation stage if you expect to sell or refinance sometime within the timeline of the loan. This will help you understand the effect any prepayment penalty will have on your plans.
8. Compare Closing Loan Documents To The Initial Letter Of Interest
It happens all the time and is a common mistake among borrowers. Never assume that the final loan documents have the same terms as those you received previously. Look out for discrepancies between the letter of interest and the final commitment letter. Any variations must be resolved with the lender before you agree to sign.
9. Loan Funding Conditions
These are usually last-minute, routine checkbox items you must satisfy before the funds are released. Some of the conditions include confirmation of funds deposited with the lender, proof of insurance etc. Failure to complete this last step will delay the loan closing!
You can see from the above that a loan signing is not something to be taken lightly. The risk involved if the project fails or you default could mean financial ruin for you, and that’s no exaggeration. The tips we have given you will help you weed out these pitfalls and put you in a better bargaining position with your lender.