How Interest Misleads on a Term Sheet
Do you EVER QUESTION the interest element on a lender’s term sheet?
If you don’t, it would pay you to do so.
Not understanding how this is derived can cost you a lot of money in finance costs.
You might be surprised to understand just how that number is arrived at and how most competing lenders' term sheets are not as comparable as you might think at the outset.
Lenders make all sorts of excuses when it comes to borrowers (and brokers) questioning their numbers, and with good reason. They know they have a lot of competition and are fearful that they will make themselves look more expensive when the detail emerges. Credit teams are viciously protective of their formulas, and one often has to use the metaphorical “crowbar” to get in!
“Don’t worry about it, it’s not important and only a projection” the lender may say “..we can only guess at this stage, etc etc”. I’m sure you’ve heard this line many times before.
The problem is, it’s not a projection, it’s reality, it's your real project they are pitching for, with real finance costs and real profit. Lenders want you the developer to be as accurate as possible with your numbers, but they often don’t seem to be as concerned when presenting you with theirs.
So what’s the problem?
As with any figures, numbers rarely tell the whole story. They are provided based on certain assumptions.
The problem with competing lenders is that lenders do not use the same assumptions when looking at your project and calculating your interest element. There is no standard practice essentially.
Otherwise you could at least begin to compare properly.
Three Areas To Check For Errors
So in order to make sure you're comparing interest elements properly you need to know where the errors may be lurking. Below are the three main areas to delve into and verify with your lenders.
1. Projections on Drawing Down
The monthly plan for how you draw down your build monies is crucial in determining the cost of your finance.
Your cashflow is crucial for 2 reasons.
Firstly, it directly affects the amount on drawn balance interest calculations; the more you draw early the more expensive the loan and vice versa.
Secondly and just as critically, if you do not provide a cashflow, you are allowing lenders to guess how you will draw. This means they are likely to use any one of three cashflow models typically acceptable, or use their own default method. The chances of their method and your cashflow matching in this instance are low and results in further errors in interest projections.
The knock on consequence is not only are the lender’s interest elements wrong because they have not used your cashflow, but they are further compromised because you now have difficulty comparing competing lenders, if they are all using different models to cashflow.
You lose out on accuracy twice over.
Essentially, you don’t have the right data available to make informed decisions about who will provide the cheapest level of interest.
2. Projecting When Sales Are Made
This is another important area that can affect what the interest element looks like in the term sheet.
When sales are projected to be made and thus deciding when funds will be paid back into the facility to clear the debt can reduce the interest burden the earlier they happen or vice versa.
Lenders tend to make one of two assumptions; they either assume all sales are made at the very end of the term, or run a phased, staggered sales return over the sales period of the loan.
Again there tends to be no standard practice amongst lenders, and as a result you have another component that can skew the interest element projection.
The first assumption is clearly unlikely but does give the borrower the worst case scenario during the term i.e. no sales made until the end of the term. If you make any sales in the months preceding the end of the term, the interest costs will clearly come down.
The second assumption is a more reality based approach but is still just as much of an assumption as the first. Who will say when sales happen or when they will complete? What the second assumption does do is make the interest element seem cheaper than the first assumption, all other factors being equal.
So it is important to understand how competing lenders are factoring in sales or not. If this varies amongst lenders, you have a further variable to re-work.
3. The Length of the Term and its Breakdown
Competing lenders rarely agree on the same term, and will often include a mobilisation period that effectively means there is no drawdown this reducing the interest element further. Some lenders can have mobilisation periods of up to 3 months so it is important to compare those elements properly too.
Tips To Compare
So due to a lack of standard practice amongst lenders, that is rarely discussed or even acknowledged, developers are provided with competing term sheets that rarely reflect the accuracy developers need in order to select the right lender.
If you are looking at competing term sheets, some tips to ensure you compare them properly:
- Ensure competing term sheets are of the same term length, with the same mobilisation, build and sales period
- Speak with your lenders in-depth on this. Most won’t want to discuss it but you must be persistent. Ask your lender what formula they used to come up with their interest element projection, and see if you can calculate it yourself and agree!
- Ensure they are all factoring sales in the same way; you can request this.
- To compare any lender’s interest element correctly, and ultimately their true and total cost of finance, ensure they have all been given your cashflow schedule. It doesn’t matter if your cashflow changes further down the line. What matters is you give them all the same schedule; a constant by which lenders can accurately calculate what your interest and finance will cost, and thereby give you an accurate method for analysing and finally deciding which of the lenders you’re comparing to finally go with.
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