Fixed, adjustable, and variable are all words that describe different types of interest rates. Understanding the differences in the types of interest rates, situations where each rate type may be better and what that can mean to make you a more efficient manager.
Fixed Interest Rate
A fixed interest rate is the most straightforward. If you have a 20-year real estate loan with a fixed rate, you will pay that interest rate and payment for the life of the loan. Fixed rates provide the least amount of risk but may be higher than the other interest rate options.
Adjustable Interest Rate
An adjustable interest rate is a rate that adjusts over time. Often an adjustable rate loan provides a set rate for a specific amount of time. After that time period, the loan pricing matures and the new interest rate is based on the current market. For example, a 20-year real estate loan with a five-year adjustable rate means that the interest rate is locked in for the first five years and after that, it will fluctuate with the market. It is important to fully understand the loan terms associated with adjustable rates and the difference between the rate lock period and the maturity date of the note. Ask your lender how many years the interest is locked and have them explain the specific terms and renegotiation process.
“An adjustable rate may make more sense if the borrower knows in advance that they plan to pay off the debt early,” said Brett Bryant, Vice President and Team Leader in FCS Financial Credit department. “The borrower can lock in the lower adjustable rate for a set period of time. At the end of the lower rate period, they can keep the current loan product and the new rate will fluctuate based on details contained in the note, refinance the existing debt at current rates or pay off the balance.”
Variable Interest Rate
The third type of rate is a variable interest rate. This rate is always changing because it is never locked in. These rates are usually tied to a margin set above a specific index such as the prime rate, discount rate, treasury rate or a rate that is established by the lender. Whenever the identified index moves, the borrower’s rate moves. Some variable rates establish a floor. This is a minimum rate that the variable rate will never fall below. So, if you have a five-year variable rate machinery loan with a floor of 2.5%, your rate will never go below 2.5%. These rates are not as common for real estate loans.
Different situations need different interest rate options. There are several factors to analyze when determining the best interest rate option. First, analyze the volatility of the current financial environment and historical trends. Currently, we have fairly low interest rates, so you may consider planning for increases in future interest rates.
“If a borrower selects a variable or adjustable rate, they need to have a plan in place,” says Bryant. “It’s important to look at your long-term strategy. If a borrower sets up a 20-year loan but plans to pay it off in 10 years, it may be cheaper to select an adjustable rate instead of a fixed rate. They need to do the calculations to see the potential savings but also do the calculations on what their payment may be at the end of the lower rate locked time period.”
Budget and size of debt are additional factors to consider. Determine if your budget is strong enough to absorb a 2-3% change and still be viable. Also, look at the size of the debt. The larger the debt the more risk to your budget when the rate moves.
FCS Financial offers a loan conversion. If interest rates move lower after your loan is closed, borrowers can convert their existing loan to a lower interest rate, shorter term or convert a variable or adjustable loan to a fixed rate loan. This option is not offered by every lender.
Understanding the difference in interest rates and comparing these to your situation will help you select the right product for your next real estate purchase.
