Despite low interest rates, some co-ops can't refinance.

Interest rates on underlying mortgages have dropped significantly in the past six months, but many New York area co-ops cannot take advantage of the cheaper cost of capital due to restrictions contained in their first mortgages, says Sheldon Gartenstein, vice president at National Cooperative Bank (NCB).

NCB is one of the largest providers of underlying mortgages to housing cooperatives in the New York metropolitan area. Gartenstein says 10-year fixed rate mortgages are now available from NCB at a rate of about 8 percent. This is more than two full percentage points below the level of a year ago and nearly three points below the peak of 1988.

The steep drop in rates, which picked up steam last Spring with the decline in yields on long-term bonds, has prompted many co-ops to rush to refinance. Even some co-ops which borrowed as recently as a year ago are trying to replace high-interest debt with the more affordable rates available today.

Unfortunately, many of these co-ops are out of luck when it comes to refinancing, says Gartenstein. Most fixed-rate lenders impose stiff restrictions on early prepayment of principal which make refinancing prohibitively expensive.

The most prevalent restriction is a so-called "yield maintenance" provision. This requires borrowers that are paying off loans early to compensate lenders for lost interest as well as reinvestment risk.

Under yield maintenance, borrowers typically pay the difference between the current interest rate on their loan and the yield on a U.S. Treasury security of comparable maturity, according to Gartenstein. For example, say the mortgage that is being paid off had three more years to maturity at a rate of 11 percent. Three-year Treasuries now yield about 4.25 percent. The coop would owe its lender 20.26 percent of the principal amount (11 percent - 4.25 percent for three years) in order to prepay its outstanding mortgage.

Yield maintenance is increasingly common due to the securitization of mortgages. While NCB does not impose yield-maintenance restrictions in its loan, it does prohibit early retirement of principal during the first seven years of a mortgage. Thereafter, NCB charges a fixed penalty equal to 2 percent of the remaining principal amount.

Co-ops that are barred from refinancing have two alternatives to take advantage of the current low interest rate environment: subordinate financing (also known a second mortgages) and unsecured credit lines. (Co-ops which require added capital for a specific need, such as replacing windows or repairing a leaky roof, also can assess their members to fund these projects, but such an approach can often create financial hardships for shareholders, Gartenstein says.)

Subordinate financing is often the preferred option, according to Gartenstein. These mortgages offer attractive interest rates (usually prime plus one percentage point, or 7 percent today) and because they are secured by debt on real estate, shareholders can deduct their prorated portion of the interest expense on their Federal tax returns.

However, first-mortgage lenders often balk at allowing additional debt to be added to the property - even if the co-op is financially sound and total debt is a modest percentage of value, says Gartenstein.