As churches become established and grow, many are faced with major building projects.  Church boards are generally comprised of volunteers from all walks of life. Not all boards enjoy the luxury of construction or finance expertise and may not be well-versed in the financial markets or familiar with some of the terms and conditions of financing offers. Here are some basics to help you understand a term sheet and know what questions to ask a potential lender.

Loan Structure
Construction Loans are short-term loans that mature when construction is complete and a Certificate of Occupancy has been received. As construction progresses, the contractor files draw requests based on the percentage of the project that has been completed. To verify the status of the work completed, an on-site inspection is typically required.  Church-owned property is collateral for these loans. These loans require monthly payments of interest only based on the outstanding loan balance. The interest rate is typically variable and fluctuates with the Prime Rate. The 30 Day Libor rate is another common index used for pricing variable rate loans. 

With Term Loans, lenders almost always offer a "take out" commitment with the construction loan. Other common names of a term loan include “mini-perm” or “mortgage loan.” Don't enter into a loan agreement without this commitment for long-term financing. Also, the amount of the construction loan commitment should match the amount of the term loan commitment. Some have accepted a reduced term commitment based on the anticipated sale of the former church site or large capital campaign gifts.     

Term loans require monthly principal and interest payments. Different lenders offer varying amortization durations for the term loan. The amortization duration is important because it can impact the amount of debt your church may qualify for. The lender will attempt to determine the church’s ability to service the debt, typically based on historic cash flow. This key ratio is easier to accommodate when payments are calculated based on a 25-year repayment duration. The difference between a 20-year and a 25-year amortization on a $1,000,000 loan at a 6% interest rate is more than $700 a month. 

Don’t forget, larger buildings often result in higher maintenance, utilities and insurance bills. The new building may also result in increased attendance, and it may be necessary to add staffing. These are reasons many churches seek lenders offering longer amortizations.

Count the Costs
One mistake many borrowers make in evaluating loan proposals is to focus exclusively on the preliminary interest rate quote. Borrowers are better served to focus on how and when the final rate is calculated as well as the other costs and fees. Covenants can also be expensive. Some lenders require Guaranteed Fixed Price construction contracts and performance bonds. Combined, these two requirements can add 3-7% to your total project cost. 

Loan Fees are generally stated as "points" and are typically ½ % to 1% of the loan amount, paid up front and often financed. Beware of paying application fees or processing fees, as these are not normally charged by experienced church lenders.  Lenders are looking at the “all-in” return on their investment (your loan), so you will often see that a lower interest rate may be offset by a higher loan fee. Unlike home mortgages, church loans generally mature in 5 years or 10 years, at the most. It may make sense to pay a higher fee for the longer commitment as the church will not be faced with the costs of refinancing the loan after 5 years.

Understand that your preliminary term sheet will likely quote you an "indication rate." This is the rate you would receive if you were documenting the loan today. After you choose your lender, it may take 30 to 45 days to close your loan. Therefore, the actual rate that will apply when your loan is documented could be very different.  

In order to avoid surprises, require the lender to define their interest rate formula. This is easier than it sounds. You simply want to know what published interest rate index the lender prices off of, as well as the spread above that index (for example, “the 5-year US Treasury note plus 2.25%” or “the 3-year Swap plus 1.90%”). Understanding the formula enables the church to accurately affect an “apples-to-apples” interest rate comparison during the lender selection process. The church can independently monitor interest rate movements, as the most commonly used interest rate indexes are published daily on the Federal Reserve Web site at www.federalreserve.gov/releases/h15/update. Avoid lenders that do not utilize a published index or cannot define their pricing formula. You don’t want to be surprised at the closing table.

Ask your potential lender to detail for you the costs associated with their loan proposal.  Many lenders will require an appraisal while a skilled church lender may not, thus saving the church thousands of dollars.  Many lenders will require a Phase One environmental report on each property owned by the church. Again, an experienced church lender may require only a site survey and data search for each property, which can also save thousands of dollars.

Some lenders may require the church to provide CPA-prepared financial statements as a prerequisite to credit approval. A seasoned church lender can usually make a credit decision based on the church's internally prepared financial statements, although CPA-prepared statements may be required thereafter.  Depending upon the size of the loan, an audit, review or compilation will be required. An audit is the most expensive, while the compilation often costs only a few hundred dollars.

Hidden costs may be involved if the lender requires a "reserve account" for the loan.  These accounts tie up church funds in low or non-interest bearing accounts, thus resulting in a need for additional borrowing.  Churches are, in effect, borrowing their own money back. 

As always, you are best served by a lender with a proven commitment to churches, extensive experience in structuring loans for churches, and a large portfolio of church loans serviced by a dedicated and knowledgeable staff.

Dan Mikes is senior vice president and national manager of Bank of the West's Church Loan Division, www.bankofthewest.com