Why is a Conversion Loan Important?
A Conversion Loan is a loan that rolls over, or converts, to a different loan type after a certain term. PrecisionLender provides you with the ability to price a Conversion Loan as a short term loan that converts to permanent financing at a later point. Without this functionality, lenders would be forced to price the short term and long term loans separately, and assume that each loan would close and fund simultaneously.
What You Will See on the Opportunity Screen
If a product has one or more Conversion options, a Conversion arrow will be displayed next to the product tab.
If the product has exactly one Conversion option, PrecisionLender will display the Conversion arrow, and clicking the arrow will immediately open the available Conversion option in another tab.
If there are multiple Conversion options for the initial short term loan, the Conversion arrow will be displayed, and clicking the arrow will display a drop-down list showing all the available Conversion options.
Pricing a Conversion Loan
The permanent part of a conversion loan is a sequential loan that begins when the initial short term loan is paid off. PrecisionLender structures conversion loans so that the separate parts of the loan never co-exist. To set up the permanent part of a conversion loan, click the Conversion arrow. Choose one of the available Conversion options if there is more than one.
PrecisionLender rolls over the total amount of the initial short term loan to the permanent loan. If you need to add funds to the permanent loan, click the chevron next to the Commitment field and add funds to the Additional Amount field.
Since the permanent part of a conversion loan begins when the initial short term loan is paid off, the rate quote for the permanent portion represents a spread above the index by default. Without changing this default, the initial rate will be indicative of rates as of the pricing date, and the loan will price at modification. If you need to lock in the rate for the permanent portion at origination, click the field next to the Initial Rate field and select the Fixed Rate Is Locked In At Origination option.
Conversion Loans and Interest Rate Risk
PrecisionLender assumes that the contract with the borrower for a conversion loan addresses risk rating, so that if the risk rating of the borrower were to fall during the first part of the loan, the lender could renegotiate the terms of the next part of the loan. The opportunity to renegotiate the loan terms after the initial short term loan period reduces the credit risk to the lender, so a conversion loan would have a slightly higher return than a similar loan with a single amortization period.
Conversion Loans and Cost of Funds
When pricing conversion loans, there are a couple of factors to take into consideration for cost of funds upon conversion to the permanent loan.
If the permanent loan is at a floating rate, we assume there's no basis risk between the cost of funds when conversion happens, and will use the 1 month point on the curve. However, if there's a liquidity premium, the duration of both the construction and permanent loan are used to determine the liquidity premium instead of just the permanent loan's duration. For example, if a 24 month construction loan converts to a 60 month permanent loan, 84 months would be used for the liquidity premium and added to the 1 month point on the curve.
If the permanent loan is at a fixed rate, it'll depend on whether or not the rate is set today ("Fixed rate locked at origination") or at the time of origination (conversion). If set today, the cost of funds will be based off of the forward curve over the conversion period. If the rate is set at the time of origination, we assume no basis risk and the cost of funds is based on today's curve at the duration of the permanent loan. If using a raw curve such as Libor/Swap, any basis points of liquidity premium will be applied as well when pricing at a fixed rate.