Five Reasons Why Nonprofits Should Consider More Than Interest Rates When Evaluating Loan Options April 24, 2023

Resources nonprofit leaders can use 

Since 1988, IFF has closed more than $1.4 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, 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. If there’s a question that we haven’t addressed before that you’d like to know the answer to, we want to know! Email, and we’ll do our best to cover the topic in a future piece. 

In recent months, headlines have been dominated by news of rising interest rates, making it more costly for borrowers to secure financing for a wide range of needs. This has a very real effect on borrowers’ ability to absorb debt, particularly among nonprofits with tight margins, but it’s important to remember that when it comes to evaluating the total cost of borrowing, rate is not the only consideration.     

To be clear, if all other terms are equal, then a lower interest rate is almost certainly the way to go. But terms can vary widely and require a deeper analysis to understand. Simply choosing the loan option with the lowest interest rate may result in less obvious costs outweighing the benefits of the low rate.    

Understanding what these costs are is essential to making the best borrowing decision, which is why we’ve compiled an overview of five key loan terms nonprofit leaders should consider beyond interest rates.    

Appraisals and Loan-to-Value Ratio  

Appraisals are an opinion or estimate of the value of a property, and most lenders tie the maximum loan amount they will extend to the appraised value (i.e., loan-to-value ratio). If a loan is tied to an appraised value, especially in a disinvested neighborhood, the loan may only be obtainable if the nonprofit borrower is able to bring significant cash to the table. Many nonprofits don’t have the cash on hand required to do so, resulting in a need to raise dollars – which takes time – or reallocate dollars – which reduces impact – to obtain the loan. For organizations that do have available cash or liquidity, understanding the cost of tying up significant cash in the project instead of using it for staffing, programs, or reserves should be part of the evaluation process. 

Fees and Expenses 

Fees, to some extent, are an unavoidable business expense of borrowing. For example, the drafting and negotiating of loan documents results in legal fees. These fees can vary widely, however, and nonprofits would be wise to ask for an estimate of legal fees early in the process.  Closing fees are another common cost for borrowing, which may include title fees and UCC searches to ensure the collateral is not already encumbered.  

Other common fees include application fees and origination fees, generally charged to cover the costs of evaluating and extending the loan. IFF charges a one percent origination fee and allows borrowers to finance that cost and roll it into the loan amount. This means that borrowers don’t have to provide cash up front to cover the origination fee before receiving a loan.    

One of the most important fees for nonprofits to understand before taking out a loan is the prepayment penalty charged by the lender if the borrower pays off its loan prior to maturity. This could occur if a nonprofit receives an unexpected donation or finds a better financing option. While paying off a loan early should result in cost savings, a prepayment penalty could wipe out that benefit or eliminate options that weren’t contemplated at loan origination. 

Financial Covenants 

Financial covenants are obligations the borrower agrees to meet during the loan term. They can include a variety of financial ratios that measure liquidity, leverage or debt service coverage and are regularly measured to ensure compliance. Even if loan payments are being made as agreed, if these other “promises” are not met, the loan is in technical default.    

While the lender can formally waive the default, it requires time and (often unwanted) attention. If the lender doesn’t formally waive the covenant violation, it shows up on the organization’s audit – creating a permanent record of the default about which donors and funders may draw conclusions. Covenant violations can also trigger a default interest rate that’s higher than what the organization was paying previously. And if the lender is looking to exit the relationship entirely, the default gives them the opportunity to do so.    

Given the legal obligations of taking on a loan, it is critical to understand the full scope of commitments being made – and potential consequences of not meeting them – when reviewing loan terms. 

Amortization Schedule 

Amortization is spreading out the repayment of a loan over a set period of time, with the borrower generally paying the same amount each month until the loan is fully repaid. A longer amortization schedule reduces the amount of money the borrower is required to pay each month, but it also means the total amount of interest paid over the course of the loan term is greater. There’s not a right or wrong answer here, but understanding the “cost” of paying more quickly versus over a longer period of time is important in evaluating what option best meets organizational needs.  

Loan Term 

The loan term is the period of time during which the borrower agrees to repay a loan, and, with fully amortizing loans, it matches the amortization schedule. When the loan term is less than the amortization term, there is a balloon payment at maturity. 

If an organization secures a loan with a term of five years and needs to refinance a balloon payment at maturity, it may have to absorb the same costs it did to secure the original loan (e.g., legal fees, origination fees). There are potential cost savings and added peace of mind that come with longer-term loans. Once the original loan is secured, the organization can know with certainty that it will not have to go through the same process again in several years, and it also mitigates the risk that the original lender will not agree to refinance the balance.    

If you have questions or would like additional information about interest rates or other costs associated with borrowing, please contact IFF’s Capital Solutions team.Click here to read about how nonprofits across the Midwest have used IFF loans to amplify their impact. 

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