Co-op Decision - Invest in the Stock Market vs. payoff the LOC

Published on April 14, 2023 by Eric Liu

Finance Financial decision evaluation

4 min READ

I was recently asked to help evaluate a financial decision for a co-op in NYC. Due to the recent interest rate hikes to fight inflation, the carrying cost for the building’s line of credit (LOC) became much more expensive. The directors were seeking financial advice to inform their response. The principal of the LOC is about $200,000 and co-op has no cash that could be used to pay off the LOC. The LOC is due in 45 months with an annual variable rate currently at 8.85% (vary at a monthly basis). Should the building levy a special assessment from the shareholders to pay off the LOC now, or should the shareholders keep the cash and invest in the stock market, paying off the LOC in the future? Which of these alternatives maximizes value of the co-op shareholders?

Alternative one: For the following 45 months, the co-op only pays the LOC interest. After this period, the co-op takes a loan (mortgage) to pay off the LOC. The building assumes a 10 year amortization with fixed rate from 7% to 8%. The total time period of paying off the LOC and interests is 13.75 years. In this case, shareholders invest the principal of $200,000 in the S&P 500 and assume an average annual return of the market for the same time horizon is 12%.

Alternative two: The co-op raises the money from shareholders now to pay off the LOC and shareholders would not be able to invest the equivalent amount in the stock market. This option avoids interest payments on the LOC.

Which option is in the best interest of the building’s shareholders? Invest in the stock market or pay off the LOC now? The co-op should use the time value of money to inform their decision by determining which option has the greatest value in 13.75 years. Let us do the numbers!

If investing in the stock market, the average long-term S&P 500 annual return is around 12%, the time horizon is 13.75 years. If the shareholders invest $200,000 in the stock market today, 13.75 years from now, the future value will be about $951,000. However, whether if the BOD should suggest shareholders to invest the money in the stock market or raise an assessment to pay off the LOC, we need to compare the next four year of interest payments and the total amount of money the building has to pay for the future loan.

How much interest payments for the rest four years? The LOC principal is $200,000, annual rate is 8.85%, compounding monthly. The shareholders will have to pay about $78,000 of interest on the LOC, then borrow a loan for another 10 years to clear the LOC principal.

If the new loan is borrowed at 7.8% fixed annual rate for 10 years, compounding monthly, then the interest payment each month will be $2405, there will be 120 monthly payments in total. The future value of the loan is about $870,000 when the load matures. There was also the previous four year interest payment of $78,000, so in total the shareholders of the co-op will pay about $950,000 if they choose to invest the initial capital of $200,000 in the stock market and borrow money to pay off the LOC. Based on the stock market return, in 13.75 years, the shareholder will have $951,000 if they invest in the stock market. In this case, it is indifferent between invest in the stock market or borrow new loans plus pay interests if the building borrows at 9%.

However, if in 45 months years the building is able to borrow at less than 7.8% fixed annual rate, say 7%, then investing in stock market will maximize the shareholders’ interest. At 7% fixed rate, the monthly payment of the new loan will be $2322 for 120 payments. After the maturity, the future value of the loan will be $804,000, with the interest payment of the LOC $78,000, the total amount the shareholders have to pay is $882,000, which is significantly cheaper to borrow compared to investing in the stock market.

What if the annual interest rate is 8%? Then the future value of the loan is $888,000 excluding the previous interest payment of $78,000. The amount of payment will be totaled at $966,000. In this case, borrowing more money to pay back the LOC makes no sense because it is way more expensive to do so.

From the above evaluation, 7.8% annual fix rate is the point where the BOD changes if the building should continue to pay interest only on the LOC and in the future take a new loan to pay off the principal versus invest in the stock market. If the building can borrow at less than 7.8%, then it is in the shareholders’ interest to invest in the stock market because it may generate net positive returns. Otherwise, if the building cannot borrow at less than 7.8%, then it is in the shareholders’ interest to pay off the LOC now.