When a commercial real estate investor is seeking financing for their project, there are many loan variables to consider. As a borrower, they may have to consider things like: the loan term, origination fees, lender, and amortization. While these variables are important, none are as consequential as the loan’s interest rate, which has a direct impact on the loan’s monthly payment and the investment’s ultimate profitability.
There are two types of interest rates that can be offered to investors in a loan transaction, fixed and variable. There are benefits and risks to each and they are the subject of this article.
What is a Fixed Rate Loan
The definition of a fixed rate loan is very simple. It is one whose interest rate does not change. The most common and widely recognized example of a fixed rate loan is a residential mortgage. The traditional, 30-year fixed rate mortgage has an interest rate that is the same for the entirety of the loan term.
There are benefits of a fixed rate loan for both borrowers and lenders.
For the borrower, a fixed interest rate means that their loan payment stays the same every month for the duration of the loan. This is helpful for capital budgeting and financial forecasting. A fixed interest rate also provides some peace of mind for the borrower because they know it isn’t going to change.
For the lender, a fixed rate loan also provides some degree of comfort because they know exactly how much income they are going to receive every month for the payment. Not only is this helpful for their financial forecasting and budgeting processes, but it also helps with capital allocation decisions.
Risks Fixed Rate Loan
Despite their reputation for relative safety, there are also risks associated with fixed rate loans. They are opposite for borrowers and lenders.
Because interest rates are constantly changing, the primary risk of a fixed rate loan for the borrower is that rates could fall below the fixed rate they are paying. If this happens they are stuck paying a higher rate for the rest of the loan term. For example, suppose an individual took out a 30-year mortgage at a fixed rate of 6%. Three years into their loan term, the interest rate environment has changed so that market interest rates for new mortgages have fallen to 4.75%. If this were to happen, the borrower is now paying more interest than they need to. Fortunately, they can always refinance their loan at the lower rate, but this can be prohibitively expensive if done frequently.
For the lender, the risk is the opposite. By making a fixed rate loan, they are locked into that rate for the duration of the loan. But, if interest rates rise, they are missing out on the income that could have been earned from charging a higher rate. To protect against this, lenders can provide variable rate loans.
What is a Variable Rate Loan?
A variable rate loan, sometimes called a floating rate loan or adjustable rate mortgage, is one whose rate changes over the term. There are two basic components to the calculation of a variable interest rate, the index and the margin.
The rate index is a mutually agreed upon index whose rates are widely published. Commonly used indices include the London Interbank Offered Rate (LIBOR) and the Prime Rate.
The second component of the calculation is the margin. This amount varies by loan and it can be negotiated with the lender. It represents an amount over the index value. For example, if the rate is quoted as LIBOR + 2%, LIBOR is the index and 2% is the margin.
As the value of the index changes, so does the rate charged on the loan. To protect against extreme changes in the rate, the borrower and lender may negotiate a number of safeguards in a variable rate loan including:
- How often the rate changes. For example, the rate could change monthly, quarterly, or annually.
- Periodic adjustment caps. Some transactions put a cap on how much the rate can change with every adjustment. For example, the Loan Agreement could say that the interest rate can’t change more than 1% up or down with every adjustment.
- Life of loan caps. Again, the loan agreement may mandate how much the rate can go up or down over the life of the loan. For example, it could say that the rate can’t change more than 2% over the entire term.
- Ceilings / Floors: Finally, the loan agreement may specify an interest rate ceiling and/or floor. The ceiling is the highest the interest rate could go and it is designed to protect the borrower from excessive interest rate changes. The floor is meant to protect the lender from excessive interest rate decreases.
For a borrower, the advantage of a variable rate loan is that the interest rate is usually lower than a fixed rate option. And, if interest rates decline over the term of the loan, the amount of interest paid turns out to be lower than originally estimated. But, this is a double-edged sword. Variable rate increases can cause the borrower to pay more interest than originally planned. If market conditions are such that rates rise high enough, a project can easily turn from profitable to money losing.
For the lender, the benefit of a variable rate structure is that they earn more money as rates rise. But, the risk also moves in the other way. If rates fall unexpectedly, they could lose money on the deal.
For a variable rate loan, the bottom line is this. There is an entire industry built around speculating which way interest rates are going to move in both the short-term and long-term. Rates are impacted by a variety of factors – including policy set by the federal reserve – and accurately predicting them can be a lucrative business. The truth is that there will always be some degree of uncertainty with a variable rate loan and it raises the risk profile of the transaction.
A fixed rate loan is one whose interest rate does not change. As a result, the payments are the same every month. This is the more conservative option.
A variable rate loan is one whose rate does change over the term. As a result, payments can vary from month to month. This option carries more risk because the profitability of the transaction can be affected if the rate and payment change in an unexpected direction.
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