The debt service on your deal is generally the highest ongoing expenses when investing in apartments. It is always important to consult with a lender or mortgage broker prior to submitting an offer so that you understand the loan programs your deal qualifies for. However, you still want to know the benefits and drawbacks of the various types of debt so that you are setting yourself and your investors up for success.
One important aspect of the debt is the type of interest rate you secure. The two main types of interest rates offered when securing an apartment loan are fixed interest rate and floating interest rates.
Here is a rundown of the differences between fixed rate and floating rate apartment loans so that you can select the ideal one for your next deal:
Fixed Rate Loans
The interest rate on fixed rate loans is locked in from day one and will not change during the life of the loan. For example, a 10-year Fannie Mae loan with a 5.5% interest rate.
The interest rate on fixed rate loans are typically tied to the US Treasury Rates. Click here for the most up-to-date Treasury rates. Generally, the fixed interest rate will be higher than the floating interest rate, all other things being equal.
Since lenders base their fixed interest rate loans on longer-term Treasuries, they have the expectation that the loan will be in place and that they will collect interest payments for a longer period of time. That said, the prepayment penalty for selling the property or refinancing a fixed interest rate loan is higher compared to floating interest rate loans.
Floating Rate Loans
The interest rate on a floating rate (also referred to as adjustable rate, ARM) loan may go up or down during the life of the loan. For example, a 10-year floating rate loan starting at 4.5%.
Most floating rate loan programs offer the borrower the ability to purchase a cap on the interest rate. That is, in return for an upfront payment, the borrower can guarantee that their interest rate won’t exceed a specified threshold.
Additionally, some loan programs offered start with a floating rate and transition to a fixed rate loan. For example, Freddie Mac has a Two-Plus-Seven Float-to-Fixed Loan program, where the interest rate is floating during the first two years and is fixed year 3 to 7. Plus, with most floating-to-fixed interest rate loans, the borrower has the ability to purchase a locked-in fixed interest rate at closing, rather than having the fixed interest rate be the interest rate at the end of the floating period.
The interest rate on floating rate loans are typically tied to the LIBOR. The LIBOR rate used will determine how often the interest rate will float, or adjust. For example, Freddie Mac bases the interest rate for their floating rate loan on the 1-month LIBOR index. So, the interest rate adjusts each month.
Since the floating interest rate is tied to a shorter-term security compared to the fixed interest rate, the borrower has more flexibility to sell or refinance without facing a large prepayment penalty.
Fixed Rate of Floating Rate?
The decision to pursue a fixed rate or a floating rate loan is based on your business plan. If the plan is to drastically improve the asset over time, a floating rate loan might make more sense because of the flexibility to sell or refinance without the large prepayment penalty.
If the plan is to not improve the asset or to make minor improvements, a fixed rate loan might make more sense because you likely won’t need to refinance or sell quickly. Plus, if you have the option to secure a supplemental loan, you can pull out some equity created without facing a large prepayment penalty.
Also, the interest rate on the floating rate loan are generally lower at closing compared to the interest rate on a fixed rate loan. If interest rates fall, you will benefit from an even lower interest rate with the floating rate loan, whereas you won’t benefit from the reduction in interest rates with the fixed rate loan. However, if interest rates rise, the fixed rate loan is beneficial because your interest rate won’t change, whereas the interest rate on the floating rate loan will increase. Although, you will likely have the option to purchase a cap on the interest rate on the floating rate loan.
Creating your pro-forma is easier with a fixed rate loan, because your monthly debt service remains the same during the entire business plan. With a floating rate loan, you may only know what your debt service will be for as little as one month. But again, you will likely be able to purchase a cap on the interest rate of the floating rate loan, so at the very least you will know the maximum debt service you’d have to pay.
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Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.