How Much Do You Need?
With the price of a new Beechcraft Bonanza hovering around $1,000,000 and a used A36 averaging $225k, buying and financing an aircraft can be a daunting endeavor. It is in line with the price of a house depending on your taste and has operating costs that likely far exceed the operating cost of a house! Your aircraft purchase could be one of your largest investments outside your house, your kids’ college, and perhaps even a business you might invest in. And loan interest could make up one of the most significant components of that cost.
Unless you have a collection of $1,000 bills, a trip to the lender is likely, certainly for a first-time plane buyer. With so much money at stake, it is a good idea to understand how the lending system works. As a financial advisor, I advise my clients to “follow the money” and understand who has what vested interest in the various components of a loan. Understanding everyone’s interests helps shape your interpretation of any recommendation that may come your way.
Fundamentals of Borrowing
The ingenious Greeks started the debt system some 3,000 years ago, with Pawnbrokers amongst the trade’s earliest purveyors. Since then, lending money has become the grease for any economic system, and we Americans have honed it to a fine art with some $46 trillion tied up in the debt/bond market.
When you borrow money from a professional (borrowing from parents, roommates, buddies, put aside for a moment), you (the borrower) take their cash from the Lender and promise to pay the money back over time. To entice and compensate the lender for loaning money to you, you agree to pay more than you borrowed, which is the “interest” on the loan.
The lender presumably has cash sitting in a box, and any intelligent person knows that keeping excess cash around is a sure way to lose value since inflation will eat at the value of that money over time. Loaning the excess cash and counting on the extra money coming in, called interest, is one way that the lender can grow the value of the cash over time. It is considered an investment by the lender.
A lender will charge a lower interest rate to entice more borrowers to borrow the extra cash. Conversely, if the lender has already loaned a lot of cash, they feel comfortable charging a higher interest rate knowing the market wants to borrow more money, assuming they are willing to pay. You have heard about this phenomenon when you read the headlines that the Federal Reserve (the “Fed”) is “tightening” the money supply. As one of the largest borrowers and lenders of money, the Fed can functionally tighten the money supply by making cash more expensive by raising the federal fund’s interest rate for the Banks, thus forcing the banks to demand higher interest rates to lend out money. Like I said, “honed to a fine art.”
Collateral
While the lender invests the cash for a period of time in the borrower, the lender will expect a return (the interest). Also, the lender needs to assure that they will be made whole in the case of the inability of the borrower to repay the loan. This is where “Collateral” comes in. Collateral is the property or asset that the Borrower assigns to the transaction that will revert to the Lender if the Borrower does not meet the obligation to pay.
The nature of this collateral defines the loan type and the risk the lender takes. In the case of a mortgage, your house is the collateral. That is a pretty safe asset in terms of its value, so the risk is somewhat lower for the Lender. They can always take the house if the borrower fails to pay, and this confidence on the lender’s part is the driver for the relatively low 2.5-5% rate associated with the mortgage. The risk is relatively low. Thus, the interest rate covers only the return needed by the lender.
A car loan has more risk because the asset backing up the loan is a depreciating asset (the car). Thus, a little higher interest rate than a mortgage is typical since the expected return needs to increase to cover the risk in the loan.
An aircraft is like a car in that you have a depreciating asset as collateral, so the interest needs to cover the expected return of the lender, plus a component of the interest will be associated with the risk of the loan.
Finally, in the worst case for the lender, there is the Credit Card loan. There is no “Collateral.” If the borrower doesn’t pay the balance (no asset was put up as collateral), the Lender may never recoup their monies. Therefore, Credit Card Companies charge 15-28% interest since the interest must cover both the expected return for loaning the money plus the significant risk that the loan defaults.
Financing an Aircraft
With this general overview in mind, I thought it would be helpful to talk to an aviation lending expert, so I reached out to Beau Baird of Republic Bank. I know Beau from my own experience of financing N2138Z. Since he focuses solely on the aircraft financing market, I thought he would be a great source of insight into how the particulars of Aviation lending.
Mortgage vs. aircraft Loan Processes, How Are They Different?
Many aspiring aircraft owners might have had experience obtaining a mortgage. The rules for mortgage approvals and processing are often defined by entities like Freddie Mac or Fannie Mae. The regulations that Freddie Mac adopted originated after the mortgage crisis of 2008 and represent a strict process with rigid “underwriting” rules. “Underwriting” is the process of examining the risk of a financial transaction and committing an entity to take it on. It is why there are a blue-million questions and supporting documents required to obtain a mortgage, and it feels like they are under your skin. There is another excellent article on the details of underwriting here.
Once a Mortgage is complete, the debt may be sold to others, like Freddie Mac, Fannie Mae, or other institutional investors. Thus, you may finance your house through Chase Bank, but they may turn around and sell it to someone else.
In the aviation market, Beau describes this as one of the key differences between Aviation loans that Republic Bank originates and home mortgages. “At Republic Bank, we are a direct lender, so our underwriting guidelines are internal. We do not sell our aircraft loans to investors.” Without the addition of extensive external underwriting, Beau continued, “Once the application is submitted, we typically have a pre-approval decision within a business day.”.
My experience was that the loan application to closing was under ten days total, but your experience might be different at another lender.
How Does a Lender Decide to Loan to You?
Any lender is taking a risk in loaning funds to you. Risk is mitigated by the Lenders by obtaining access to an asset (collateral) just in case payments aren’t made. And, they add more dollars into the payment stream through higher interest rates. This creates dollars from presumably many loans, the majority of which will pay, compensating for those who do not. Its security by diversity.
In addition to the stream of funds from increased interest mitigating risk, a Lender will want to know the Borrower, and the Credit Score is an excellent way to understand the borrower. Republic Bank, for instance, wants to see “…Borrowers with a 730 or higher credit score with no bankruptcies, repossessions, delinquencies, or other judgments.”, according to Mr. Baird.
Beyond knowing the person via credit score, the lender will also manage risk on a particular loan by examining the total debt the borrower may have before and after the loan, both in terms of the amount of money you owe and the size of the payments per month—more about this to follow.
How much can the Lender Loan?
Several factors drive the amount of money that you can borrow for an aircraft including:
- Your ability to pay
- how much debt do you already have
- the risk associated with loaning money to you
- the value of the collateral
A lender will primarily look at your ability to pay by ensuring you have enough cash flow each month to make payments. One misconception is that a bank will loan you money, no matter your income, if you have “enough money in the bank.” This is untrue; unless you put the money up as collateral, the bank wants to know you can pay the money back from your cash flow month to month. You can have $2,000,000 in the bank, but you will likely not get a loan unless you have the income to cover the payments. (note: I am ignoring things like Margin Loans and so forth, which are beyond the scope of this document).
The lending industry uses several metrics. The Debt to Income (DTI) ratio is the ratio of monthly debt service payments to monthly income. DTI is calculated by summing all your monthly loan payments and dividing that by your gross monthly income. In the case of Republic Bank, according to Beau Baird, “Our guidelines require an after-loan debt-to-income (DTI) ratio of 40% or less”. Another way Lenders look at your monthly payment burden is to examine just this loan (ignoring all the others) divided by your gross monthly income. This is called the Payment-to-income (PTI) ratio, and Republic, for instance, looks to have a PTI ratio of 15% or less.
We discussed collateral earlier, which is one component in determining how much can be loaned to you based on the airplane in question. The Loan-to-Value (LTV) ratio is essential to the lender’s calculation. This is the ratio of how much is being loaned to the aircraft’s value in the aviation loan case. The plane’s value is established by the lesser of the purchase price or the market value of the aircraft. According to Beau, Republic Bank establishes the aircraft’s market value in several ways: “For most piston-powered “pre-owned” aircraft, we use Vref and Aircraft Bluebook for values. For pre-owned turbo-prop and jets, we typically require a desktop appraisal.” notes Beau.
The LTV ratio limits the risk of the lender having a collateral asset depreciating in value to the point that it no longer protects the lender. After all, if they end up “repossessing” the aircraft, they have to get their hands on it, turn around, and sell it with all that attendant cost.
With that in mind, the lenders set rules. Republic, for instance, sets the following guidelines according to Beau:
“Typically, we can lend up to 85% of purchase price or valuation (whichever is less) for Part 91 use piston-powered and turboprop aircraft. For jets, our max LTV is 80%. We lend on certified airplanes 1970 or newer, with less than 10,000 airframe hours (7,500 or less for piston), complete logbooks, and no major damage history. Our loan limits are $100k up to $3MM. If the aircraft will be leased back to a flight school/flying club, our max LTV is 75%.”
All these guidelines, rules, and metrics are designed to ensure the lender does not step into a loan that the borrower can’t keep up with. It also assures the lender can recoup their funds if the borrower reneges on the commitment to repay.
How is the Interest Rate Determined?
The interest rate you might pay on a loan will be one of the most significant components to consider. Say you were to purchase a $350,000 aircraft, and the Loan to Value was 80% (thus requiring a 20% down payment). If the interest rate were 5% and the loan period ten years, the monthly payment of $3,394.10 would drive a total interest cost of $87,291.58 over the course of the loan. That is 25% of the price of the airplane! A 1% increase in interest rate would take the payment to $3,552.66 with a total interest cost of $106,318.73, or nearly 1/3 of the cost of the aircraft.
As you can see, getting the lowest rate possible is critical. And there are many issues at play here. There are market issues and borrower issues that the lender must consider. Beau explained, “Most aircraft lenders correlate their aircraft loan rates with a “cost of funds” index such as Treasury or Swap rates. Our bank’s internal cost of funds tends to mirror Swaps.” These finance terms reflect that the funds they loan come at a cost to the lender, and this must be built into the rate they charge you.
According to Beau, the borrower brings many factors to the deal, driving interest rates. He explains, “Many aircraft lenders tier their loan rates based on credit score, personal liquidity/net worth, loan size, loan term, LTV, and other factors. Generally, the less risky the loan, the lower the rate.“
As this is written, the Federal Reserve continues to fight against inflation using rate increases. The Fed Rate tends to have an immediate impact on variable rate loans. Long-term loans (like mortgages and aircraft loans) tend to fluctuate based on longer-term rates like Treasuries and Corporate Bonds. Those rates have gone up significantly in the last few months, and most predict they will continue going up for the remainder of this year. From a historical perspective, both mortgage and aircraft loan rates are still attractive. As of this writing, our 15 and 20-year fixed aircraft loan rates are in the upper 5% range.
Partnerships and the Like?
In a simple world, people would own aircraft like they do a car. But given the high cost, possible legal liability and tax issues might drive an owner to think about partnerships and LLC’s for instance. In Republic’s experience, Most aircraft loan clients register their aircraft in an LLC with the person as the Borrower. But, Republic is also OK with the corporate entity as the Borrower with the majority owners as the Personal Guarantors. The structure does not impact interest rates, or loan terms, other than closing costs might be slightly higher for corporate loans versus personal loans.
If two people approach Republic as a partnership (perhaps a legal partnership) to finance the purchase of an aircraft, Republic will pull on their long experience. In their experience, Most of the time, the partners form an LLC to have the aircraft owned and registered, and then the two individuals are each the personal borrowers. Some prefer to have the corporate entity as the borrower and individuals as personal guarantors. Either way, each partner will submit their own loan application and financials. Republic will combine their qualifications for underwriting purposes.
Republic will allow up to 4 borrowers or “entities” per transaction. Flying clubs are unique, according to Beau, and Republic will finance a purchase. However, they require at least one of the flying club officers to be a personal guarantor, meaning if all else fails, the guarantor is on the hook for the payment even if the club cannot pay itself.
The Engine, the Panel?
As an aircraft ages, an engine overhaul or panel upgrade will be in the owner’s future. Each can be a significant investment; if readily available funds are not available, another trip to the lender might be a solution.
Lenders look at the whole picture, according to Beau from Republic Bank. Republic typically allows for engine overhauls and/or avionics upgrades to be included in the financing of the aircraft. We typically finance up to 85% of the “cost basis” or “after-improvement” value (whichever is less). The “cost basis” is the aircraft purchase price + the cost of upgrades. The after-improvement value will include the proposed upgrade in the loan collateral valuation. If there is an existing lien on the aircraft, Republic will include that payoff in our loan, thus creating a complete refinance. At closing, the funds associated with the upgrade or overhaul will be held in escrow by the title/escrow company. When the upgrade work starts, Republic will typically release ½ of the funds to the vendor. Once the work is complete (as evidenced by a vendor invoice and logbook entries), Republic allows the title company to release the remaining escrow funds to the vendor.
These complexities are a prime reason working with a specialized aircraft financing bank is critical.
Beau Baird has been a banker/lender for 28 years, originating many types of loans, including consumer loans, complex commercial loans, and everything in between. He has been with Republic Bank for 18 years, with the last five years solely focused on aircraft lending.
Putting it All Together
Complexity surrounds an aviation loan. You need to make sure that you can afford the loan, that you can make the payments from cash flow that you can generate, and understand how the loan and equity in the airplane interact. We highly suggest that you work with a seasoned financial advisor to understand how the loan fits into your financial life. They can fold the loan and the aircraft ownership into a comprehensive financial plan for you. It could prove to be the second most important decision you make after the one that brought you to this page, the passion to buy an airplane.
If you would like to speak to a financial advisor about your aircraft ownership dreams, schedule your free consultation.
Beau Baird
VP, National Aircraft Lending Sales Manager
Republic Bank & Trust Company
661 South Hurstbourne Parkway
Louisville, KY 40222
P 502-562-8827
C 502-457-1846
F 502-498-1268
Based in Louisville, KY, and 2nd largest community bank in Kentucky, Republic is a $6.5 Billion bank . With banking centers in Kentucky, Indiana, Ohio, Tennessee, and Florida, the bank offers aircraft lending in all 50 states. Republic Bank is celebrating its 40th anniversary this year. I believe we have a competitive advantage in the market because we are large enough to compete with the big banks in technology, yet we are still small enough to offer “small bank” service.