Interpreting HOA Banking Trends in a Changing Rate Environment

Over the past few decades, there has been a steady decline in interest rates. This trend persisted for 40 years until it reached its lowest point in 2020. As interest rates decreased over this period, many banks expanded their loan portfolios, which included extending loans to Homeowner Associations (HOAs).

HOA Loans in a Sinking Interest Rate Environment

These loans typically featured extended repayment periods and fixed interest rates, ensuring that interest income remained constant throughout the loan's duration. Engaging in long-term lending with fixed interest rates proved to be a lucrative endeavor for lenders.

Lenders experienced a steady stream of interest revenue from the interest accrued through loan payments. Most lenders established their pricing models based on a risk-free alternative use of their funds plus a credit margin. In simpler terms, an HOA loan is priced at the risk-free Treasury note yield plus a spread that reflects credit and liquidity.

Liquidity Charges

Banks knew they could invest in Treasury notes, earn a risk-free 5% return, and enjoy considerable liquidity. Liquidity refers to the ability to sell Treasury notes at any time to generate cash. Conversely, HOA loans carried more risk than US Treasury obligations and offered virtually no liquidity. Therefore, lenders believed they should be compensated appropriately for assuming risk and sacrificing liquidity. The interest earnings served as compensation for banks, and a two percent rate premium seemed equitable. These principles reflect the fundamental tenets of banking.

The Unexpected Dual Advantages of HOA Loans

Banks reaped a twofold advantage from the decline in interest rates. Initially, they expected to earn a margin over Treasury notes when lending to HOAs. However, as Treasury note rates decreased while the interest rates on their HOA loans remained fixed, their yield advantage grew. Fixed-rate loans made when Treasury yields were higher became more profitable when those yields fell, because the gap between the loan rate and the risk-free yield widened.

HOA Deposits Gained Value

Banks derive revenue not only from loans but also from the deposits made by their customers. These deposited funds serve as the capital base from which banks extend loans to other customers at higher interest rates. Typically, banks aim to minimize the interest paid on deposits to maximize their income from loans. Historically, when interest rates were low, many banks showed little interest in accumulating additional deposits since they already had an abundance of interest-free deposits. Consequently, banks had little incentive to adjust their pricing strategies to attract more deposits.

In recent years, there has been a notable shift toward prioritizing deposit accumulation over lending, which has had repercussions for HOA banking. Many banks found certain fixed-rate HOA loans had become unprofitable as interest rates increased. Long-term fixed-rate loans made when rates were low stopped covering the bank's cost of funds once Treasury yields rose above them. The spread banks expected on those loans turned negative.

With risk-free Treasury notes offering yields of 4% or 5%, banks can lucratively redirect low-cost deposits into government-issued bonds. As higher interest-rate opportunities emerge, many banks have intensified their competition to attract HOA deposits. Unfortunately, this heightened focus on deposit gathering has led several banks to revise or discontinue their HOA loan programs.

Shift in HOA Lending Principles

Banks typically have two avenues for exiting lending programs. The first method involves halting the acceptance of new applications outright. While this straightforward approach may strain existing relationships, it remains an honest albeit uncomfortable tactic. The second method entails offering uncompetitive rates, which can signal borrowers that the lender is seeking to phase out its involvement in the business. 

However, if a borrower is willing to accept a higher-than-market rate, the lender may still extend a loan. While this second approach may come across as disingenuous, it is entirely within legal bounds.

As HOAs navigate their financial management, they must remain cognizant of the evolving landscape. A financial institution that once aligned with their needs may no longer be the best fit. Like other vendor relationships, banking affiliations warrant periodic reevaluation to ensure they remain conducive to the HOA's objectives.