Note modification can reduce interest rates for affordable housing borrowers

Affordable housing borrowers across the country are enjoying the benefits provided by the US Department of Housing and Urban Development’s (HUD) expansion of its Interest Rate Reduction (IRR) program that permits an interest rate modification on loans insured by the Federal Housing Administration (FHA). This program, often referred to as the note modification program, is not new. In the past, HUD primarily permitted note modifications on struggling properties or properties in default on their loans. Now, due to increased loan volume and historically low interest rates available to borrowers, HUD has expanded the program, permitting borrowers of performing properties to reduce interest rates on FHA insured loans through a greatly abbreviated application process rather than requiring them to go through a complete, traditional refinancing.  According to HUD lenders, the cost to the borrower is minimal: since most of the fees associated with the note modification can be rolled into the transaction, the only out-of-pocket fees the borrower incurs are borrower legal fees.

Over the past several months, borrowers with FHA insured loans (221(d), 223(f), 202) have refinanced their properties in conjunction with this program, resulting in enormous cost savings and improved financial positions for affordable rental housing projects. In the current low interest rate environment, note modifications are worth considering.  As one lender shared with us, the current low interest rates can result in such significant rate modifications that it is possible for a borrower to pay large prepayment penalties – even up to 8-point (8 percent) – in a note modification and still come out ahead financially. In light of the low interest rates, now is the time for affordable housing borrowers to explore their refinancing options. The prepayment penalties are rolled into the new interest rate, so the new rate is higher than it would otherwise be in a normal 223(f) transaction, but due to the current low interest rate environment, the new rate determined by the note modification can still be considerably lower than the loan’s original rate. 

HUD lenders we work with have indicated note modifications are fast and easy and require very little documentation or effort from the borrower. A borrower need only obtain three documents to apply for the note modification. Specifically, the borrower will need to submit an Authorizing Resolution and a Certificate of No Change from their lawyer. The borrower must also provide an updated set of current financial statements for the property (do not need to be audited). The lenders suggested that the average borrower is able to accomplish the document submission in about two weeks’ time. In addition, HUD’s turnaround time on note modifications is significantly shorter than the turnaround time required for traditional loans. In order to enact a note modification, the borrower must work through the specific loan servicer that is handling the loan in question.

Despite the ease of the note modification program, for some borrowers, a traditional refinancing (223(a)(7)) may be a more appropriate choice. The more appropriate choice will be dependent on current rate on existing loan, and existing term, lockout provision, and prepayment penalties. Consider the following differences:

HUD Note Modification – Interest Rate Reduction

FHA Insured 223(a)(7) - Traditional Refinancing

Drops interest rate on existing loanDrops interest rate on new loan
Retains existing terms and maturity date on loanWill change of terms & maturity date on loan
Does not permit an increase in loan proceedsPermits borrower to increase loan proceeds
Does not permit extension of term/amortizationPermits an extension of term/amortization period

In addition, careful evaluation of a note modification versus a refinancing is advisable for certain specific types of FHA insured loans, namely 202 loans and loans tied to Section 8 contracts. For borrowers for whom this is applicable, there may be considerations with your existing Section 8 if you undergo a note modification, so please be sure to discuss these issues with your HUD lender to understand the potential implications to your project of a note modification.

Finally, two HUD lenders suggested to Baker Tilly that depending on the age and maintenance needs of the property, a traditional 223(a)(7) refinancing may make the most sense for the project.  

In an example a lender shared with us, the original note was a 420 month 223(f) transaction for $6,020,000 at a 4.20 percent rate back in 2010. At the time of the loan modification, the remaining term was 365 months with $5,637,909.14 left in principal. The loan modification kept the existing maturing and principal the same, simply lowering the rate to 3.75 percent, saving the borrower $17,583 in annual principal and interest payments. The total cost of the transaction to the borrower was less than $5,000 in legal fees and it took about two months to lock in the new rate.

The current interest rate environment has created some significant cost saving opportunities, but every situation is unique and should be evaluated with your financial and legal advisors.

For more information on this topic, or to learn how Baker Tilly housing industry specialists can help, contact our team.