Question

Matthew needs a long-term mortgage to finance a new office building and is trying to decide between two loan proposals. Loan #1 is a 10-year term, 20-year amortization loan. Loan #2 is a 10-year term, interest-only loan. However, as is often the case, Matthew is very confused. He notes that both the upfront fee and contract mortgage rate are slightly higher with the interest-only loan compared to the partial amortization loan. As a result, Matthew feels this is backwards since the interest-only loan has a lower debt service payment compared to the amortizing loan, which implies that the interest-only loan has a higher debt service coverage ratio (DCR) for the lender and hence is less risky. Is Matthew correct? Explain your answer fully.

Answer 1

Increasing the term of a loan would decrease the installment amount of each year. That will reduce the denominator and thereby increase the DSCR

The amount of interest is a part of the denominator of the DSCR formula and if the rate of interest is reduced to some extent, the interest amount will reduce and that would result in a decrease in the installment amount. That would decrease the denominator and hence would improve the DSCR