Town Council Rolls the Dice on Interest Rates

By GEORGE SOUTHERN
Cape Charles Wave

November 13, 2013

Cape Charles Town Council is poised to refinance nearly $1.2 million in debt at its Thursday, November 14, meeting, when Council members are also expected to endorse a proposal to borrow an additional $1 million.

Most of the existing debt was for water and sewer infrastructure. Money allocated to hook up new wells was instead used to buy the new library building, so now the Town needs to borrow $300,000 for the wells, among other projects.

Current Town debt is at a fixed interest rate. But the Town has contracted with a Richmond financial advisor, Davenport & Company, who recommends paying off two fixed-rate loans in favor of a cheaper variable-rate loan.

Anyone with a home mortgage is likely to understand the difference between fixed-rate and variable-rate loans. Fixed-rate loans are issued at a higher interest rate because the bank bears the risk if interest rates go up in future years. Variable-rate loans have lower rates at first, because the customer (in this case the Town) bears the risk of future interest hikes.

In 1992 the Town borrowed $1.58 million to construct the water tower. That was a 40-year loan at a fixed rate of 5 percent, and there are 19 years left to pay. Davenport recommends paying off that loan and replacing it with a 20-year loan from PNC Bank. The PNC interest rate would be 2.65 percent for the first 10 years, which amounts to a substantial reduction in annual payments.

But there’s a catch: In 2023 the interest rate would change to reflect whatever the rate might be at that time. While that future rate is anybody’s guess, almost no one thinks it will match the present historically low rates. And some people fear that hyper-inflation could bring sky-high rates in future decades.

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Davenport Senior Vice President David Rose told the Wave that he doesn’t see a repeat of the 1970s in the cards. That’s when the prime interest rate quadrupled from a low of 5 percent to a high of 20 percent. But if Rose turns out to be wrong, Town taxes and utilities could rise dramatically come 2023.

The Davenport proposal presents cash-flow scenarios year by year, showing what the Town would pay under the existing loans versus a new variable-rate loan. The problem with those cash-flow scenarios is that it’s impossible to know what the Town’s costs would be beginning in 2023. Davenport solves that problem by simply assuming that the 2.65 percent rate will not change for the full 20 years of the loan. When pressed, Rose admitted that such a scenario was unlikely, but he nevertheless felt that the substantial cost savings the Town would realize over the first 10 years would compensate for increased costs over the succeeding 10 years.

The Town does have another option, although the Davenport firm doesn’t recommend it: pay off the existing 5 percent loan and replace it with a 3.1 percent fixed rate loan from Sun Trust Bank. The catch is that the loan is only for 15 years, so annual debt service would be substantially higher than on the 20-year PNC loan. (Of course, after 15 years the Sun Trust loan would be paid off, while debt service on the PNC loan would continue for five more years.)

That Town Council will approve the Davenport proposal for a variable-rate loan is a foregone conclusion; items rarely make the agenda that are not preordained. But the option to borrow an additional $1 million is a little more complicated, requiring a public hearing. The plan is to approve the refinancing at Thursday’s special meeting, advertise the public hearing the following week, hold the hearing December 5, and then approve the new $1 million loan at Council’s regular December 19 meeting.

The Town information packet for the special meeting may be read by clicking here. The packet includes a list of capital improvement projects totaling nearly $2 million:

Sewer infrastructure: $590,000
Water infrastructure: $340,000
Trail, Alley, Parking: $375,000
Harbor improvements: $575,000