August 13, 2019

How You Can Tell What Your New Low Rate SHOULD Be

In 1972, Steve Jobs was given a particularly difficult project by Atari. The company offered him $700 if he could reduce the number of chips required for a computer game. Because Jobs felt the assignment was a bit beyond his capability, he reached out to his friend, Steve Wozniak, and offered to split the promised $700 fee evenly. Wozniak surpassed expectations so much that Atari paid $5,000 to Jobs rather than the $700. Jobs said nothing to Wozniak and paid him $350, which Wozniak thought was 50% of the fee. Wozniak didn’t find out until years later, stating that he cried when he learned the truth. 

The same thing is happening to a growing number of borrowers who have fixed-rate bank loans. With the recent precipitous fall in rates, some banks are “Jobbing” borrowers by offering substantial interest rate reductions on current or terming loans. These reductions, however, represent only a portion of what the borrower could receive in the open market with the bank pocketing the difference. Consider the following case of a Midwest specialty group who had two years remaining on its loan:

The bank offered to drop the group’s 4.55% interest rate to 3.55% and extend a new 10-year term. Excellent deal, right? Not at all! In actuality, the bank increased its profit margin by 59 basis points and picked up an additional profit of $1,200,000. That is money that should have been in the borrower’s pocket and not the bank’s.

Here is How It Works

  1. When the borrower first financed in October of 2018, the cost of funds was 3.03%. The 1.52% difference between the cost of 3.03% and the rate of 4.55% is the bank’s spread (profit). 
  2. The cost of funds has now dropped to 1.44%. The difference between the bank’s newly offered rate of 3.55% and the cost of 1.44% is 2.11% rather than 1.52%. Thus, the bank has increased its spread from 1.52% to 2.11%.

On this loan, each 0.01% has a present value of $16,000. That means the larger loan spread is costing the borrower $944,000 more than if the bank had maintained its original spread. 

And Here is How to Get the Full Advantage of the Lower Cost of Funds

  1. Determine the cost of funds for the term and amortization of your loan on the day of closing. (These costs are available through any derivatives trading company or CMAC Partners)
  2. Subtract the cost of funds from the fixed rate to determine the bank’s original spread / profit.

Determine the new cost of funds for the replacement loan and add the original spread. In the example above, it would be 1.44% + 1.52% which equals a rate of 2.96% instead of 3.55%