For investors, interest rates can make a significant difference in whether a specific project is attractive or not. As interest rates rise, the margin for profit may shrink, requiring the investor to approach with caution. In some cases, a variable or adjustable interest rate can offer a tool to increase the deal’s feasibility. The reason for this boost is that the initial rate is lower than the investor can obtain for a long-term fixed-rate loan.
For example, suppose that the interest rate on a 30-year fixed-rate loan is set at 6 percent, but the available starting rate for an adjustable loan is 4.5 percent. That difference in rate might bring a purchase within reach. For a $250,000 loan, the monthly payment would be $230 less with the adjustable loan than with the fixed rate.
Often, a variable interest rate loan will have limits to how much the rate can increase, both overall and within specific time parameters. The reason for these limits is to reduce the risk to the borrower that could result from a rate shock. With an interest rate cap, the borrower knows what the maximum rate is, and how much it might rise during any given period.
For example, if you accept a variable rate mortgage loan for a home purchase, the rate may be fixed for a few years, and then subject to increase if rates are higher. The rate and fixed term are reflected in the loan’s title, such as a 5/1 ARM. That indicates that the starting rate will be fixed for five years, and then the rate can rise yearly.
The initial rate increase would also be established in the loan agreement. For example, the increase might be held to one or two percent at the initial reset, and a similar yearly amount, with an overall lifetime cap of five percent.
If interest rates are rising, accepting an adjustable rate loan will typically allow the borrower to access lower payment rates at the beginning of the loan term, due to a starting rate that is below market. If rates continue to rise, the borrower will know what to expect at the end of the fixed term. The borrower can sell if necessary, or refinance the mortgage, particularly if rates drop during the fixed term portion of the loan. Since rates for investment property loans are typically higher than those for personal occupancy, investors may want to consider adjustable rate loans.
Adjustable rate loans are attractive to lenders because they protect the lender from having capital tied up in loans that are issued below the current market rate. For example, suppose your bank gives you a 30-year loan with an interest rate of 5 percent. After a few years, the current market rate is up to 7 percent, but the lender can’t change the amount you pay.
Unless you voluntarily terminate the loan by refinancing (unlikely in a rising rate environment) or selling, the lender is losing access to a higher margin. If, instead, they give you a slightly lower starting rate, the financial institution can preserve its ability to increase the rate you pay as the market conditions change. This approach allows more stability for both parties to the loan.