In a recent article, I outlined the various factors that impact interest rates. Understanding those factors is important, but as we mentioned in the article, not all lenders are the same. You might remember that I even suggested that investors ought to shop around before committing to a specific lender; or the very least utilize the help of a loan broker who does that for them. So, what does an investor need to know before doing that? In this article, my goal is to summarize how the terms of different kinds of loans (specifically related to commercial lending) are impacted by the various factors that influence interest rates.
Before we delve into the various types of loans, there are specific aspects of lending that are imperative to understanding this discussion:
Short Term Versus Long Term Loans
Depending on the length of time that an investor is borrowing debt, the terms and rates of their loan can vary. Typically, longer terms loans. offer lenders more long term predictability and marketability, and therefore will provide borrowers better terms and lower rates on their loan. Additionally, borrowers will be provided the opportunity to access a fixed rate. Short term loans, on the other hand, are usually offered at higher rates and with adjustable rates; this means that the interest that a borrower pays can vary depending on how well the economy is performing.
Personal Guarantee Versus Non-Recourse Loans
Another important distinction to be aware of when obtaining a loan is between a recourse loan and non-recourse loan. A recourse loan places responsibility on the borrower to repay the loan and allows the lender to seize collateralized assets after a borrower fails to pay; the individual is personally guaranteeing the loan. A non-recourse loan, however, is defined as a loan for which the borrower is not personally liable; typically, the real estate only will be the collateral for the loan. For investors, a non-recourse loan provides more protection in the case that their property stops performing to expectations to cover the debt.
Benchmark for Interest Rates
The last bit to mention before we continue is that for all loans provided by financial institutions, there is a benchmark that helps determine what the base for interest rates will be, so as a borrower, you’ll want to be aware of the two chief benchmarks: The fed fund rate and the prime rate.. The federal fund rate is the interest rate on overnight, interbank loans, while the prime rate is the interest rate that banks charge their top corporate customers who have the strongest credit. Think of lending as a pyramid. The base of all rates for financial institutions is the fed fund rate – lenders must offer debt at a higher rate than the fed fund rate so that they can make a return (the spread is their profit margin). The prime rate will be above the fed fund rate, but is the lowest return a lender will get when providing financial assistance to a borrower. Lenders offer these low rates to this selection of borrowers because of the stability in their financial position. The next level up is where the investor will fall. Their rates will be higher than both the fed fund rate and prime rate, and will vary depending on their companies or their personal qualifications, as well as the collateral involved in the deal. The lender will assess the risk associated with the loan, and determine an interest rate based on their analysis. This idea is important to remember when considering how the below loans relate to the fed fund rate and prime rates.
Personal Loans
Personal Loans and Credit Cards
The most well-known types of loans are personal loans and credit cards. Both of these are offered to individuals based on their personal credit and income-to-debt ratio. These loans offer lenders no collateral (unsecured loans) and therefore often come with higher interest rates and adjustable rates. The benchmark for the rates on personal loans and credit cards are often based on LIBOR and can vary drastically depending on the borrower’s qualifications. Because of the high interest rates and variability, personal loans and credit cards are typically unwise choices for real estate acquisitions – a borrower should seek out better terms!
Home Equity
If you own a home, you may qualify for a home equity loan, home equity line of credit (HELOC), or cash-out refinance. These options for accessing capital all require you to use your current home as collateral for the loan; they provide lower rates compared to the interest on personal loans or credit cards, and they can allow investors access to quick capital for an opportunistic acquisition. The rates on home equity loans are based on all the aspects of the economy, including the current fed rate, prime rate, and US Treasury yield. They can often provide the lowest rates because of the security they offer for the lender.
Commercial Loans
Conventional Loans
A conventional loan. is the most common type of loan that a borrower will obtain when they are purchasing commercial real estate; conventional loans are provided by a lending institution, such as a bank, life insurance company, credit union, etc., and their mortgages are backed by whatever commercial real estate the investor is purchasing. Lenders usually require the borrower to put down between 20% and 30%, depending on the asset and terms of the loan.
The term and amortization of the loan can vary. For example you may have a 15 year term with a 25 year loan amortization schedule. That means you will have a principle balance at the end of the 15th year. These are long term loans that often provide investors the opportunity to access a fixed interest rate. The rates that lenders offer borrowers are often determined by the current 10-year US Treasury since it is considered one of the benchmarks for the overall health of the US economy.
Bridge Loans
The bridge loan differs greatly from the conventional loan – It is a short-term loan used until a person or company can secure permanent long-term financing. In essence, it is “bridging” a gap during those times when financing is needed but revenue isn’t yet available. Bridge loans provide investors the opportunity to gain quick capital; however, their interest rates tend to be higher compared to conventional loans. The interest rates that an investor will obtain for a bridge loan will vary by lender and will also be determined by their qualifications and the risk associated with the deal.
Hard Money Loans and Owner-Financing
Not all investors seek funding from financial institutions; some may not qualify for any of the traditional loans, so they turn to private equity for their capital via avenues such as hard money loans or owner financing . Seeking capital from private parties is a much different process than going to a financial institution because there is no base that the lender is working with – they do not stick to the same benchmarks that banks do. Instead, they can determine their own terms and interest rates based on their personal agenda.
Understanding Debt
There are risks and benefits associated with each kind of debt or loan, and each can vary depending on the status of the economy; at the end of the day, a well-executed business model that leverages debt can be a great avenue to help investors build wealth.
Want to know what the inverted yield curve is? Read this Article. Also, If you are curious about the CMBS and CLO markets, read this Introduction.
