How Do Adjustable Rate Mortgages Work?
An adjustable rate mortgage also called a floating rate mortgage changes monthly, every 6 months or annually. The rate is determined by an index plus a margin with the index being the current daily LIBOR or Prime Rate. For example: If your mortgage is tied to the monthly LIBOR rate as an index which is 0.45% and the margin is 2.50%, the all in rate will be 2.95%. If the rate is a monthly adjustable then it will change monthly based on what the 30-day libor rate index is every month. In other words, your rate could go up or down during the term of the loan. Fortunately, all adjustable rate loans have a “Cap” which protects the borrower. This specifies the maximum the rate can go up. Always make sure the cap is something you can afford. These loans also have a floor which protects the lender. This specifies the lowest the rate can go.
Although the index changes, the margin stays the same. So if you watch the index, you should be able to determine where your adjustable rate is headed. In my book “The Encyclopedia of Commercial Real Estate Advice”, I disclose trade secrets about how lenders set their interest rates. This is really a convoluted system benefiting lenders where they can always add to the margin what they want to increase their earnings. When rates are set to an index plus a margin, the rate appears to borrowers to be set in stone by some government entity. But the reality is, the lender often has added as much as they think the market will bear to the margin to make as much as they can. When they are competing, most lenders will lower their margins and thus lowering their rates.
Many regional banks start their commercial loans out with a fixed-rate term – lets say 5 to 10 years. Then the loan converts to an adjustable rate mortgage for an additional 20 or 25 years. Community banks will often have a 10-year term for commercial loans where the rate is fixed for the first 3 – 5 years and then converts to an adjustable rate mortgage for the remaining term. The rate often adjusts every 3 years until the 10-year term is up.
We are taught that a long-term fixed-rate is better than an adjustable rate floating mortgage. The word floating certainly doesn’t sound very stable or safe does it? Fixing a rate so you don’t have to worry about adverse changes might seem like the best strategy, but this really depends on your objectives for the property. The gold standard when purchasing a home is the 30-year fixed/30-year amortization mortgage. But when buying a commercial property, an adjustable rate will make more sense in certain circumstances. Here are the pros and cons of an adjustable rate mortgage:
Pros of an Adjustable Rate Commercial Mortgage
1. Much Lower Rate – Adjustable rate mortgages tied to the LIBOR rate have averaged 1.50% lower or more than a 5-year fixed loan in 2020. On a $500,000 loan, this is a savings of $7,500 annually, or $15,000 on a million dollar loan. With no prepayment penalty you can always refinance to a fixed-rate mortgage if rates go too high. Adjustable rate mortgages have “Caps” which protect the borrower and do not allow the rate to go over a specified amount. They also have “Floors”, which protect the lender which specify the lowest the rate can go.
2. No Prepayment Penalty – Keep in mind, that with the exception of federally chartered credit unions, all long term fixed-rate commercial mortgages have prepayment penalties. We are talking about fixed rates from 3 to 30 years. If you are not sure what your strategy is for the property, whether you are going to fix and flip it, sell it when rents go up in 4 years when it is worth a lot more, or hold the property indefinitely for retirement, then having an adjustable rate loan without a prepayment penalty could make sense. If you do decide to sell early before the loan matures there will be no prepayment penalty. If you decide in the future you really want to hold the property long term, you can refinance without a penalty to a long term fixed-rate mortgage.
3. Perfect for Properties that Need Repositioning
If you are purchasing a commercial property that needs rehabbing, cosmetic improvements like new floor coverings, appliances or paint, or just needs time to raise rents and lower expenses, an adjustable rate mortgage is an advantage. This will be the lowest rate at your bank. You can likely arrange to have the rate convert to a fixed-rate mortgage when the work is completed and the property is stabilized. Or if you cannot qualify for a bank loan – a bridge loan from a private debt fund lender can get the job done. These are almost always adjustable rate interest only loans. Although the rates are higher 7.00% to 10.00%, the interest only payments are usually affordable.
Cons of an Adjustable Rate Commercial Mortgage
1. An Adjustable Rate Can Move Up Quickly – In January of 2005 the 30-day LIBOR rate was at 2.589%. A year later in January of 2006 it rose to 4.572%, an increase of just under 2.00%. Prime rate was at 11.75% in December 1978 and then moved up to 15.25% a year later.
2. Long Term Fixed Rates Often Go Higher When Adjustable Rates Do – So if your adjustable rate has increased rapidly and you want to refinance into a long term fixed-rate, that rate will likely have moved up too. So you might have been better off getting a long term fixed-rate at the beginning.
3. Your Objectives for the Property or the Economy Changes – Well, you were planning on fixing and flipping this property in 2 years and a much lower rate adjustable rate loan seemed perfect. But now there is an unexpected recession and you cannot raise the rents and increase the value as planned. So you need to hold the property longer. If your adjustable rate is going up then this can be a disaster.
By Terry Painter/President Apartment Loan Store and Business Loan Store
Author of “The Encyclopedia of Commercial Real Estate Advice” a Wiley Book