How To Position Loans For the Debt Averse


There are many reasons why some customers are more debt-averse than others.  Research has shown that millennials are particularly reluctant to take on debt and are also teaching their kids, Gen Z, to avoid borrowing.  However, lenders need to understand how to position their loan products and provide advice for when taking a loan makes good sense for the customer. The most critical financial determinant of when debt makes sense is measuring the business or property’s internal rate of return.  In this article, we highlight the real economic cost of debt as measured by cash cost, and not stated interest rate.


IRR Defined

A property’s or business’s internal rate of return (IRR) is the value it generates during the time frame of ownership.  The IRR calculates the percentage of interest the investor earns on each dollar invested over the holding period. One crucial cost of ownership of property or business is the cost of debt – assuming that debt is part of the capital structure.  Some borrowers say that they are debt-averse and prefer to take minimum debt or pay down debt as quickly as possible. Commercial lenders must understand how to calculate the economic cost of debt for a borrower and how that cost factors into an investor's IRR decision making (the latter is a topic for a future blog).


Cost of Debt Defined

Most smart investors understand the difference between the interest rate and cash flow and can convert one to the other.  Most bankers are used to talking about the cost of their product (whether it is debt or equity) in terms of interest rate, but borrowers do not pay a percent amount on their loan.  Instead, borrowers pay a dollar amount (cash flow) on their loan, and an interest rate is a number used to calculate that cash flow.  Just as many sophisticated investors prefer to make investment decisions based on cash-on-cash return, most sophisticated borrowers also measure the cost of debt based on cash flow. 

Let us use an example loan as follows:  $1mm loan, amortized over 25 years, 4.25% interest rate, results in monthly P&I payment of $5,535 (depending on the accrual method used).  In simple terms, the cost to carry the loan is 4.25% per year or $65,591 per year.  But this is not the economic cost of the $1mm loan.  For the following reasons:

Interest: The two components of the monthly payment are principal and interest.  The economic cost of the loan to the borrower is the interest portion and not the principal (a return of someone’s capital – the bank’s).  The interest component is the cost to the borrower – although lenders should always calculate the ability of the borrower to return the capital over time. 

Tax: Of the interest component, the first monthly payment is $3,593, and the annual interest is $42,670.  Assuming the loan is a 10-year balloon, over the life of the loan the borrower pays $375k in interest with a net present value (NPV) of $308k.  But the $308k is not the economic cost of the loan to the borrower because interest is tax-deductible.  Tax rates vary widely across the country and individual to individual.  However, if we assume a 30% effective tax rate (between corporate and individual), then the 4.25% stated loan rate is effective after-tax rate of 2.98% (4.25% * (1 – tax rate)).  The NPV of the loan interest payments is lowered from $308k to $215k.

Depreciation: The story does not end there.  When debt is used to finance depreciable property (as is often the case) the depreciation is also tax-deductible.  Assuming 80% LTV, 50% of the asset can be depreciated over 25 years, and the same 30% tax rate, the loan rate is lowered from 2.98% to 2.39% and the NPV of the loan interest payments is lowered from $215k to $154k.

Inflation: There is one more significant and often overlooked benefit of debt.  The bank hands over $1mm of cash to the borrower and the borrower makes small principal payments and a final balloon payment at the end of the loan.  The bank expecting to receive its capital of $1mm returned without any inflation adjustment.  However, inflation at 2% is lowering the cost of the loan substantially.  While the borrower returns the entire $1mm of the borrowed funds to the bank, the value of the $1mm returned is $841k, and the difference is the loss to the bank because of inflation (of course the bank is being compensated with interest rate payments).  In reality, the economic cost of the loan to the borrower is lowered from 2.39% to 0.67% because of inflation over the ten years, and the NPV of the loan payments is lowered from $154k to $49k.  

Putting This Into Action

In summary, the economic interest cost of the loan is shown below.

Calculating the true cost of debt


In the example given ($1mm, 25yr amortizing, 4.25% rate, 10yr balloon), a sophisticated borrower calculating the economic cost of the debt understands that the loan interest rate is the equivalent of a nominal rate of 0.67% per annum.  If the borrower can invest in real estate or a business that can generate more than 0.67% per annum, then all return above 0.67% per annum accrues to the equity investor – the borrower. 

This is a fantastic revelation for two reasons: 

First, borrowers should want as much debt as their lenders will supply them.  Lenders should also want to book loans because the borrower’s cost of debt and the lender's return on debt are not equivalent (especially because of distortion caused by taxes) and because the lower economic cost of the loan enhances the borrower’s ability to pay it.  Lenders can still make profitable loans even if the borrower’s economic cost is only 67bps per annum.

Second, lenders should, however, be cautious about over-leveraging debt because such a low IRR hurdle for investors causes excess risk-taking and this is where lenders should use debt yield to constrain leveraging assets whose long-term value can be volatile.