by Scott Rolfs

For most churches, the idea of obtaining financing through a bond issue is a very new or unique proposition. However, bond financing for major projects is a time-tested and conservative method to obtain needed funds. Every day, many major U.S. corporations issue bonds to finance various corporate projects. They choose to do this because bond financing can provide these organizations with some substantial financial and strategic advantages over traditional bank financing. The same principles and benefits that IBM or Coca-Cola obtain by issuing bonds can be obtained by a church when it chooses to finance its project. One way to examine the benefits of this method of financing is by dispelling some myths about bond financing.

Myth #1: Bond Financing Requires Church Leaders To Sell Bonds To The Membership

When a corporation issues bonds to the public to finance a major project, its managers do not sell the bonds to employees or customers. They retain an investment banking and brokerage firm to underwrite the issue, and the brokerage firm sells the bonds to its customers. There are certain companies that provide "firm" underwriting to churches, whereby all of the church's bonds are sold to outside investors by the underwriting company under a firm guarantee.

By utilizing a company that provides firm underwriting, the funding of a bond issue can occur in a similar manner to a commercial bank loan. The church can obtain needed long-term financing without having the church members purchase bonds. Neither the pastor nor the building committee need to sell any of the bonds to the congregation.

Other bond underwriters in the marketplace offer "best efforts" underwritings, where there are no guarantees that all the bonds can be sold. Usually, these types of companies do require the church membership to purchase some of the bond issue. Whether you choose firm or best efforts, either option provides your church with many of the financing advantages to be discussed.

Myth #2: Bond Financing Is A Costly Alternative To Commercial Bank Financing

Before discussing the cost-effectiveness of bond financing, it might be a good idea to discuss how loan fees are paid with a bond financing. Bond financing requires the church to pay loan fees in the form of up-front points, known as the underwriting discount. However, these points do not need to be paid by the church in cash at closing. The underwriting discount is deducted from bond proceeds; therefore, the church does not receive the entire amount of bond proceeds. The fee is used to compensate the investment brokers who actually sell the bonds. It also compensates for the interest rate risk that a firm underwriter takes when they purchase the entire issue before having the bonds sold to investors. Using this method, the loan points, or fees, can be financed over the life of the loan.

To someone not familiar with how a bond issue works, the idea of paying up-front points is a new concept. However, by paying more in the way of up-front costs, the church "purchases" more attractive loan terms, which are described as follows:

Low Interest Rate

The church "purchases" a lower interest rate. Currently, 15- and 20-year bond financings have interest rates below the prime rate. Most conventional bank loans are based on the prime rate or a treasury bill rate plus one to three percentage points. A church can obtain interest savings of one to three percentage points with a bond issue. On a multimillion dollar loan, this type of savings easily can surpass the cost of the bond issue in the first year or two. After factoring in the cost of the underwriting discount, it is possible that the effective interest rate with a bond issue is the most cost-effective financing option.

Long-Term Security

The church "purchases" a long-term loan. With a bond issue, the low rate previously discussed is fixed for the 15- or 20-year term of the loan. The church never has to worry about rising interest rates or about refinancing a three- or five-year bank note. The church might have to refinance a short-term bank loan during a time of rising or high interest rates. This could mean substantially higher mortgage payments. Since most nonprofit organizations spend all of the money they receive, the question to ask is, "Where would we get additional funds to pay the higher interest cost associated with the new loan?" In many cases, it could mean cutbacks in needed ministry programs.

A church is in the business of ministering, not taking financial risks. A 15- or 20-year fixed rate loan eliminates a substantial portion of the risk involved with borrowing on a multimillion dollar project. What if a church borrows $3 million from a bank to finance a new construction project on a three or five-year basis? In three or five years, the loan either must be repaid entirely or refinanced. If attendance and growth projections are not met, a bank may not be willing to refinance the loan. Furthermore, if interest rates have risen, it is possible that the church may not be able to afford the new higher mortgage payment, again making it impossible to find an institution that will refinance the loan. By financing with a bond issue, you do not expose your organization to this risk. Remember the hyper-inflation and high interest rates of the 1970s and 1980s? People in the 1920s thought that the United States had entered a new era and that the stock market would never suffer a major decline. It is not safe to assume that the United States economy has somehow become immune to high inflation and high interest rates on a permanent basis. These periods do occur on a cyclical basis. With a bond issue, you know your total cost for the financing--down to the penny--since it is a fixed-rate, full-term loan with no balloons.

Open-Ended Mortgage

When borrowing for a major project, ask yourself whether there is going to be a need to borrow money for future projects down the road or for future phases of construction. With bond financing, the church "purchases" an open-ended mortgage provision. The loan documents for most bond financings contain provisions for a church to issue additional bonds at a later date without having to refinance the original loan. If a church chooses traditional bank financing, it would most likely have to refinance the first loan at the time of the second loan. This will entail additional fees, expenses and possibly loan prepayment penalties. Furthermore, if interest rates have gone up, the rate on the initial loan also would have been increased. However, if a church chooses to finance its first project through bonds, the additional financing simply can be added on to the old loan balance without changing any of the terms of the original loan. However, interest rates on the new money would reflect the then-current market rates.

The open-ended mortgage feature could be the most valuable component of a bond financing. Should an organization choose traditional bank financing for its first project, it is possible that rising interest rates and prepayment penalties would make it cost prohibitive to ever obtain additional financing for future projects at a later date simply because traditional bank financing requires an organization to refinance the entire first loan to obtain additional funds. However, bond financing allows a church to build and grow over the years as its budget permits, all the while providing the safety and security of a fixed interest rate. A commercial bank may give a church excellent terms for the first loan, knowing that they will be able to increase the interest rate the next time around when financing is needed for phase two of a construction project. Alternatively, if church leaders know that this will be the only project that will require financing, and the money is needed for a short-term, commercial bank financing may be a better route.

Myth #3: A Bond Issue Will Not Provide The Flexibility Our Church Needs

A bond issue can provide a church with greater flexibility than conventional financing. The loan covenants the church must comply with under a bond issue usually are more attractive than the covenants required in a traditional bank loan. Before deciding on a lender, be sure to ask for copies of all loan documents for review by the church's finance committee. Many churches decide on a lender without reviewing all of the fine print associated with the loan, choosing the lowest rate or lowest fee proposal. Commercial bank loans may have loan covenants that do not fit your operational needs. For example:

Prepayment Penalties

When choosing a financing source, be sure to check whether the loan document allows you to prepay all or part of the loan. This is an important feature since church leaders may have a pledge program set up with the proceeds going to debt retirement. Additionally, ask your lender what their prepayment penalty is if you want to refinance the loan at a later date with another lending institution. Many commercial banks do not allow you to refinance a loan unless you pay a prepayment penalty. Most bond financing vehicles do not have any prepayment penalties or restrictions. You "purchase" total prepayment flexibility up-front by paying the underwriting fee.

When negotiating with a lender, ask to have the prepayment penalty removed, or if you agree to a prepayment penalty, you should always attempt to make sure that the penalty is a known amount, not based on a formula with many variables. A common technique that many commercial lenders use today is to set a prepayment penalty based on the "mark-to-market" value of the loan on the date of prepayment. In other words, assume that a church takes out a bank loan and decides to refinance the loan with another institution two years later. The loan documents may require that you pay a prepayment penalty to the bank based on the potential lost profit to the bank for the remaining years that the loan would have outstanding. The lender's lost profit usually is based on an extremely complex formula relating to the interest rate at which the bank can reinvest repaid loan proceeds. This type of variable prepayment penalty could result in prepayment penalties so high that it may not be financially possible to switch lenders or get out of your deal.

Additional Spending And Borrowing

Many traditional mortgage loan documents attempt to limit the amount of money that a church can spend on additional capital projects. For example, the church may not spend more than $50,000 per year on capital projects without obtaining the permission of the lender. These types of clauses can be limiting to a growing church. These covenants usually are not seen with bond financing. While your lender may be reasonable in its application of these covenants, you are still putting your church's ability to grow in the hands of a third party.

The same covenants are quite common as they relate to additional borrowing. A church may be limited in the amount of outside borrowing that it can do, even if the money only is borrowed from its members or on an unsecured basis. It is not unreasonable for a lender to put some limits on your ministry's ability to borrow more money from other sources; however, just be sure that you can operate with these restrictions. Again, most bond financings do not have such restrictions.

Additionally, many bank loan covenants require the church to maintain certain cash deposits with that institution, and the bank dictates required ratios of assets and liabilities. Bond financing allows churches to keep their local banking relationship.

Bonds: An Alternative Worth Considering

If your church needs financing for a major project, a bond issue could very well be the most attractive and cost-effective way to borrow. As mentioned, bond financing gives churches a conservative way to borrow a large sum of money while providing great flexibility. This especially is true as the amount of the required financing increases over the million-dollar level. Whether you are a senior pastor, church administrator or finance committee member, it makes sense to check out some of the major bond finance companies as an alternative to borrowing from a local bank. Very few churches should be borrowing multimillion dollar sums of money without at least examining proposals from bond finance companies. There are a number of good companies in the bond financing field, all offering different variations of products and services. Hopefully the items previously discussed will give your ministry some points to consider when choosing a financing package.

Scott Rolfs is a Vice President and Manager of B.C. Ziegler and Co.'s Church and School lending division. Ziegler, based in West Bend, Wis., has been providing firm bond underwritten financing to churches and schools since 1913.