Welcome to the second installment of the “Ask the Expert” series, where we ask an expert real estate professional your questions about different investment strategies.
If you have a specific question you’d like to ask an expert, let us know in the comment section below.
Today’s question is about the two types of interest rates.
When securing a loan, the two types of interest rates offered are fixed rate and floating rate.
A fixed interest rate is locked in and will not change during the life of the loan. A floating (or adjustable interest rate) may go up or down depending on the market.
The question is: what are the pros and cons the fixed interest rate vs. the floating interest rate loans?
We asked this question to Scott Lebenhart, the Director of Acquisitions at AshcroftCapital, and here is what he had to say:
“Different lenders offer different options in terms of floating rates vs fixed rates. A lot of this depends on where the lenders are getting their money from and how they need to price it in order to get the returns they are looking for. Many of the longer term lenders (such as Fannie and Freddie) offer fixed rate debt since they tie their loans to treasuries. Since these lenders have priced their loan with the expectation for the loan to be in place for a long period, there is usually a high prepayment penalty if we wanted to sell or refinance the loan early. Most of the shorter term lenders will offer floating rates tied to the 1 month [LIBOR]. Since the loan is tied to a shorter term security, the floating rate loan offers a lot of flexibility to sell or refinance the loan without a large prepayment.
The pros and cons of this is really property specific. At a high level, they are both good options, however we typically chose a floating or fixed rate to match the business plan of our deals. For deals that we plan on drastically improving overtime, a floating rate loan makes the most sense since it provides ultimate flexibility to sell or refinance the deal once we complete our business plan. For deals that we will be improving (but not as drastically), we have found that longer term fixed rate debt is a better option. Although it is difficult to refinance the fixed rate debt early in the hold, we are able to get supplemental loans to capture some of the value that we have created through our business plan.”
In summary, the floating interest rate is ideal when you are adding a lot of value and require flexibility. If you expect to sell or refinance your deal, you can do so without paying a high prepayment penalty. The major potential con of the floating interest rate loan is that it can change during the business plan. If interest rates go up, your interest rate will go up as well.
The fixed interest rate is ideal when you are adding some value and don’t expect to sell or refinance after completing a value-add business plan. As long as you have the ability to secure a supplemental loan (click here to learn how to secure a supplemental loan), you can recapture some of the value created without selling or refinancing. The other pro is the locked in interest rate, meaning you won’t be negatively affected by rising interest rates. The potential con is your inability to sell or refinancing without paying a prepayment penalty, with is why fixed interest rate loans are better for longer hold periods.
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