Refinancing Quandary: Going Forward

The terms of our existing underlying mortgage prevent us from refinancing until next year. Meanwhile, we’ve watched in frustration as interest rates have risen from all-time lows…and it looks like they’ll continue to climb. Is there any way that we can lock in today’s rate even though we can’t refinance for another 10 months?

Many boards are asking this same question. Fortunately, the answer for some is “yes.” What you are referring to is called a forward rate commitment (or, simply, a “forward”). This is a mechanism through which a borrower receives a lender’s promise today to provide a definite amount of new financing on or before a specific future date at a certain, fixed (or “locked”) rate.

Actually, there are two types of forward commitments. One is more commonly called an “early rate lock” and refers to the process of setting the interest rate on a new loan at, or soon after, application to guard against an increase in rates during processing. This type of forward requires a large “good faith” deposit (usually two to three percent of the loan amount) to hold the rate for no more than 30 to 60 days but has no other costs. The lender typically refunds the good faith deposit at closing, unless the borrower fails to close within the required 30 to 60 days. In that case, the lender usually keeps the deposit as a fee for having locked the rate.

The second type of forward became quite common in the world of new construction, where the success of a project often depends on the cost of permanent (fixed-rate) financing after the project has been completed and occupied. To improve their chances, many developers are willing to pay a lender a substantial fee up front to secure a fixed interest rate before construction even begins. Some developers prefer a higher fixed rate on their permanent loan instead of an up-front fee, and others negotiate some combination of up-front fee and higher fixed rate. Whatever the structure, these fees and higher rates function like a “premium” on an “insurance policy” against increases in interest rates during the construction period.

Forward commitments have migrated to other mortgage markets as yield maintenance prepayment penalties and prepayment lockout periods have become more common. Therefore, depending on their individual circumstances, an early rate lock or forward commitment might make sense for some cooperatives. However, as is often the case with financial decisions, the answer for your co-op would come from crunching the numbers.

The benefit of locking in a lower rate today for a new loan to be closed sometime in the future is easy to grasp. The cost of doing this, though, is not easily understood, especially if the new loan is scheduled to close many months in the future. The explanation begins with the concept of the time-value of money. Most people accept that a dollar received today is more valuable than a dollar received a year from today. How much more depends on current interest rates as well as the outlook for rates in the future. If we turn this concept around, and instead suggest that a dollar received a year from today is worth less than a dollar received today, we’ll be getting close to the way a lender thinks about early rate locks and forwards.

Predicting interest rates is risky business and, the longer the prediction, the riskier it becomes. That relationship is depicted graphically by the “yield curve,” which is a chart that plots interest rates against maturity (time). You can find the current yield curve in the financial sections of The Wall Street Journal, The New York Times, USA Today, and other major newspapers.

Most of the time, the yield curve is a line that slopes upward to the right. This shape indicates the market’s demand for a higher rate of return (i.e., interest rate) as the length of investment (i.e., risk) increases. For example, investors usually would require a higher rate of return for a seven-year investment than they would for a three-year investment. Similarly, a lender typically would charge a higher interest rate on a ten-year loan than it would on a five-year loan.

Every once in a while (like now, for instance), the usual upward shape of the yield curve changes to a flatter, or even downward-sloping, line. Historically, a “flattening” of the yield curve indicated an unsettled market, and an “inverted” yield curve presaged a recession. However, in today’s global, 24/7, electronically connected market, such changes function more as fodder for financial talk shows than as reliable economic indicators. Nonetheless, the current flat yield curve means that long-term interest rates are virtually the same as short-term rates. That means that now is a particularly good time to go shopping for a forward.

If you were looking for a new underlying mortgage today, every lender would be quite comfortable in quoting you an interest rate, and honoring that rate for 30 to 60 days until you close. If, however, you were looking to lock in an interest rate today for a new underlying mortgage that you planned to close, say, ten months from now, the reaction from the lending community would be somewhat different. First of all, some lenders would not be interested in helping you at all because they do not offer forwards. The few lenders that do would quote higher interest rates depending on how far into the future you planned to close. However, because of the flat yield curve, the forward premium would be less than if the yield curve had its usual upward slope.

At any point in time, the pricing of a forward reflects the prevailing interest rate market. Typically, the base spread of a forward is somewhat higher (10 to 20 basis points) than the spread on a loan for current delivery. Then, a premium (1 to 3 basis points) is added to the base spread for every month that the closing is pushed into the future. So, if the spread on a new underlying mortgage for your co-op would be 100 basis points over the 10-year treasury bill, if closed now, the spread for a 10-month forward on the same loan might be 130 basis points. The question for you, then, is whether you believe rates will increase by more than 30 basis points over the next ten months. If your answer is “yes,” you might opt for the forward commitment. If your answer is “no,” you’d wait out the ten months and look for a new loan then.

Since we now are in what most people think is an “upward rate environment,” many co-ops are talking about early rate locks and forward commitments. However, before getting too excited about beating the market, remember that any forward commitment (however short) is really nothing more than an expensive bet on the future trend of interest rates. In other words, it’s a gamble. If asked, most shareholders would prefer that their board not gamble with their financial future.