Put plainly, spreading out the repayment of a loan over a set period of time agreed upon by the lender and borrower, with the borrower generally paying the same amount each month until the loan is fully repaid with interest. This creates predictability for the borrower, which can be especially helpful for nonprofits, which often rely on funding sources that ebb and flow from year to year. One of the most common alternatives to fully amortizing loans are loans with balloon payments (see below).
Resources nonprofit leaders can use
Since 1988, IFF has closed $1.3 billion in loans for almost 1,100 nonprofits, putting flexible capital in the hands of changemakers to help bring their visions for stronger communities to life. This year, as part of a content series launched last month, we’ll be sharing some of what we’ve learned over the past 35 years to help nonprofit leaders better understand the types of loans available to nonprofits, how to leverage financing to amplify impact, how to evaluate and manage facilities projects, and more.
Though it’s commonplace for individuals to finance large purchases – like houses and cars – and for-profit companies regularly borrow capital to achieve business goals, debt is less likely to be considered a strategic tool by nonprofits. In our experience, one of the reasons for this is that the risks of borrowing are well known while the benefits aren’t fully understood. While there’s no arguing that taking on debt does involve risk, and it’s not a solution for every funding challenge nonprofits face, financing can be a powerful tool to expand organizational capacity and impact.
Understanding how this tool can be wielded to amplify mission-driven work, however, first requires a basic understanding of the vocabulary of community development finance. While Community Development Financial Institutions (CDFIs) like IFF try to make the experience of borrowing as “user friendly” as possible to increase the flow of capital to communities underserved by mainstream financial institutions, there’s no shortage of financial jargon for nonprofit leaders to navigate before seeking, closing, and paying off a loan.
Below, we’ve compiled a list of terms to help demystify the process. Click the terms for brief explanations of what each one means, and, where relevant, to access additional resources related to the topics. For starters, “lender” refers to the financial institution (i.e., CDFI or bank) that is lending the money, where “borrower” refers to the nonprofit organization who is borrowing the money.
An opinion or estimate of the value of a property. There are generally three approaches to determine value: replacement cost approach, income approach, market comparison. Most lenders require an appraisal by an authorized firm or individual before extending a loan to a borrower for a facility project, but appraisals make it harder and more expensive for most nonprofits to access affordable debt – which is why IFF has provided loans without appraisals for our entire 35-year history.
Unlike fully amortizing loans (see amortization above), loans with balloon payments are not fully paid off at maturity (see definition below) with the set monthly payment and require a large payment (the balloon) at the end of the loan term to satisfy the borrower’s financial obligation to the lender. A balloon payment will either need to be paid in full at maturity (a potentially significant cash outlay) or refinanced with a new loan (with potentially unfavorable terms).
A short-term loan made to provide immediate capital while awaiting long-term funding or financing. For nonprofits, bridge loans can be a good solution when grant funding for capital projects has been awarded but there’s a lengthy wait for receipt of funds or when an organization has to be reimbursed by a funder for services provided. Bridge loans are also useful for nonprofits engaged in capital campaigns, with the loan enabling the organization to proceed with its plans while converting pledges from donors and funders to cash (read about a nonprofit who utilized a bridge loan for this purpose here).
Most often, just another word for cash, but it can also refer more broadly to any financial resources that an organization has at its disposal.
A legal event finalizing the agreement between the lender and borrower, during which all of the relevant documents are signed. The closing is the last step before money changes hands between the lender and borrower.
An asset – often real estate equipment, or investments – that a borrower pledges to the lender until a loan is repaid. If the borrower is unable to pay back the lender, the collateral can be sold by the lender to recoup the value of the loan provided.
A formal statement, in writing, from the lender, that makes a legal commitment to the borrower to loan them a certain amount of money. The commitment letter outlines key terms such as the interest rate (see definition below) and loan term (see definition below), as well as any obligations the borrower needs to meet for the closing to take place. For a nonprofit, an example of this could be meeting a certain threshold for capital campaign pledges to demonstrate the strength of the campaign.
The process a lender goes through before making a loan commitment to a borrower. Underwriting involves examining financial records to determine the likelihood that the borrower can repay the loan. The length of the underwriting process can vary widely, and depends in large part on how quickly and completely the borrower can provide documents such as financial statements, budgets, project costs, and board member details.
In the simplest terms, debt is a financial obligation. For a nonprofit that takes out a loan to build a new facility, the amount borrowed is the debt owed to the lender.
Payments required to be made by a borrower to repay a loan (i.e., principal + interest…see definitions for both terms below).
A ratio used to determine how comfortably a borrower can cover its debt payments while taking into consideration all of the organization’s financial obligations. To learn more about the debt service coverage ratio and how to calculate it, click here.
Money set aside to guarantee the repayment of a loan, often in an escrow account. The establishment of a reserve can be a stipulation for a loan to close, as it reduces the risk to the lender that the borrower will be unable to make regular payments from its operating budget.
Interest is the cost of borrowing money from a lender, and it is usually communicated as a percentage (i.e., the interest rate). This is what is owed to the lender in addition to the principal (the amount of money borrowed). Interest rates vary from one lender to the next, so it’s important for nonprofits to explore options with multiple lenders. It’s also important to understand that the interest rate is only one component of loan “cost.” Fees, collateral requirements, loan-to-value ratio (see definition below), and other terms can factor greatly into the overall affordability/cost of a loan. Flexibility is also important, so stipulations like prepayment penalties and liquidity requirements should also be considered in conjunction with the interest rate offered for the loan.
Because loans are legal obligations, there are often legal fees associated with borrowing money. It’s important to ask lenders for an estimate of these fees to gain a more complete understanding of the costs the organization will be responsible for when borrowing money.
Using borrowed money (like a loan) to purchase an asset (like a new facility) that will enable the buyer to increase revenue beyond the costs associated with borrowing the money needed to make the purchase. There’s risk involved in leveraging, but nonprofits can use leverage to achieve greater impact in certain circumstances. Gaining a full understanding of the potential upside in leveraging for certain transactions, as well as the risks of doing so, is critical before committing to the strategy.
Money a lender makes available to a borrower to use when needed, up to a limit set when the line of credit is established. Interest is paid only when the line of credit is used, and, as soon as the amount of money borrowed is repaid, it’s available to be borrowed again (this is commonly referred to as “revolving”). Lines of credit can be effective tools for nonprofits to manage cash flow based on the timing of donations, grants, etc.
Financial resources that can be quickly deployed to meet an organization’s needs, like cash.
A ratio that compares the size of a loan to the appraised value of the property it’s being used to purchase. Or, in other words, how much of the purchase price the loan covers. A lower LTV ratio is often more desirable to lenders, but CDFIs are often more flexible in making loans with higher LTV ratios than traditional financial institutions. IFF does not require appraisals for non-profit projects and therefore does not have any LTV requirements. This can provide nonprofits with greater opportunity to use leverage to increase their impact.
The date at which a loan must be repaid to the lender.
A document that gives a lender the legal right to take possession of an asset, like a building, if a loan isn’t repaid. In most cases, the lender would then sell the property to recoup financial losses associated with the loan.
A borrower’s written promise to repay a loan according to the terms agreed upon with the lender before money changes hands.
The payment of all or part of a debt prior to its due date. Some lenders charge prepayment penalties to borrowers, and it’s important to know before taking on a loan whether it can be repaid early without incurring additional costs. For a nonprofit, an unexpected contribution could provide the organization with the ability to pay off a loan earlier than anticipated, enabling the organization to reduce the amount of interest paid on the loan.
The amount of money that’s borrowed, which must be paid back to the lender with interest (see interest above).
A financial statement that shows projected income and expenses after taking future events into consideration to understand how those events will impact the organization’s financial situation. For example, a pro forma statement for a nonprofit considering a loan to acquire a new facility would reflect the costs associated with taking on debt and the costs associated with operating the new facility, in addition to any new revenue the organization is able generate because of the facility (e.g., a federally qualified health center with more exam rooms in a new facility could serve more patients, thus increasing the Medicaid reimbursements received for services rendered).
Changing the terms of the loan after it has closed, which can be accomplished by taking on a new loan to pay off the old one – either at maturity (see definition above) or beforehand. While there are costs associated with refinancing, it can be advantageous to do so if it enables an organization to lower the interest rate, change the payment schedule, or otherwise alter the terms of the agreement with the lender in a way that benefits the organization.
See “collateral” above.
The length of time during which the borrower agrees to repay the loan, whether through amortization (see above) or with a balloon payment at the end of the term.
The Uniform Commercial Code (UCC) is a standardized set of laws and regulations for transacting business. A UCC lien or filing is a form that a creditor (lender) files to provide notice that they have an interest in the property of a debtor (borrower). The creditor will have the right to the property in the lien until the financial obligation has been repaid by the debtor. For example, if a lender provides a loan to a nonprofit to purchase a new piece of equipment, it will file a UCC lien on that equipment to collateralize its loan.
While the terms above provide an introduction to the vocabulary of borrowing, it’s not an exhaustive list. If you have questions or would like additional information, please contact IFF’s Capital Solutions team.