Forward Rate Calculations for Construction and Development Loans
The funding of advances for a construction or development loan is in the future, so applying a forward rate to the funding costs includes compensation for the risk.
Forward Rate and Funds Transfer Pricing
The funding of advances in the future adds additional risk to the profitability of the construction or development loan. Applying a forward rate to the funding costs ensures that the return on equity (ROE) includes compensation for this risk. The forward rate is applied to the advances based on the draw schedule of the loan.
What Is a Forward Rate
A forward rate is an interest rate applicable to a financial transaction that takes place in the future. Forward rates are calculated from the spot rate yield curve. The forward rates are adjusted for the cost of carry to determine the future interest rate, which equates the total return of a longer-term investment with a strategy of rolling over a shorter-term investment. It may also refer to the rate fixed for a future financial obligation such as the interest rate on a loan payment.
The Forward Rate Calculation
Forward Rate Calculation Example
Consider the following example of a customer cash flow schedule for a floating-rate construction loan:
| Time Frame | Payment Date | Principal Amount | Remaining Principal Balance |
|---|---|---|---|
| 0 | N/A | N/A | $200,000.00 |
| 1 | 10/17 | $0.00 | $200,000.00 |
| 2 | 11/17 | $0.00 | $200,000.00 |
| 3 | 12/17 | $0.00 | $200,000.00 |
| 4 | 01/17 | $0.00 | $533,333.33 |
| 5 | 02/17 | $0.00 | $533,333.33 |
| 6 | 03/17 | $0.00 | $533,333.33 |
| 7 | 04/17 | $0.00 | $533,333.33 |
| 8 | 05/17 | $0.00 | $866,666.67 |
| 9 | 06/17 | $0.00 | $866,666.67 |
| 10 | 07/17 | $0.00 | $866,666.67 |
| 11 | 08/17 | $0.00 | $1,200,000.00 |
| 12 | 09/17 | $1,200,000.00 | $0.00 |
Continuing with this example, if today is September 17, then the one-month rate from the following yield curve is calculated forward for each of the future advances:
Forward rate calculation for the one-month rate, four months from now:
Forward rate calculation for the one-month rate, eight months from now:
Forward rate calculation for the one-month rate, 11 months from now:
The forward rates for this loan:
The cash flows for this loan:
For this example, two Funds Transfer Pricing (FTP) fields are defined on the page:
- Data Cost Value - All Outstanding Balances
- Funding Curve Basis - Actual/Actual