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 Trying to decide between fixed and variable loans? It’s not always a straightforward choice. We’ll break down the differences between fixed and variable-rate loans, providing insight to help you make an informed decision for your investments. Whether you’re a seasoned investor or just starting out, understanding these loan types is crucial for your financial strategy.

Given the recent economic changes, it is important to discuss the difference between fixed and variable-rate loans before applying for them. Prior to 2021, syndications didn’t scrutinize debt as much, but now, many are facing capital calls due to it. This is critical to think about because the biggest property expense is typically the mortgage payment, making debt a significant consideration.

FIXED LOANS

Fixed-rate loans mean the interest rate remains constant for the loan’s duration, usually 15 or 30 years for residential properties, and 5, 7, or 10 years for commercial properties. Fixed rates tend to be slightly higher because banks want to ensure profitability over the loan term. Government agencies like Freddie Mac and Fannie Mae often provide fixed-rate loans, offering stability and predictability over commercial real estate loans of 5, 7, or 10 years

VARIABLE LOANS

Conversely, variable-rate loans fluctuate monthly, with banks favoring these due to reduced risk on their end. Adjustable-rate mortgages (ARMs) are a form of variable loans; for example, a 10/1 ARM means a fixed rate for 10 years, followed by potential adjustments. 

THE DIFFERENCE BETWEEN FIXED AND VARIABLE LOANS

Variable rates were popular when interest rates were low, but they come with risks. Banks are more stringent with fixed-rate loans, whereas variable loans are more flexible and quicker to secure. However, the interest rate can change monthly, leaving borrowers exposed to market fluctuations. While fixed rates tend to be slightly higher, they provide certainty and predictability. Term length is another consideration; fixed loans often span 5 to 10 years, while variable loans typically offer shorter 3-year terms.

Investors often prefer fixed loans to mitigate interest rate risk, especially in times of uncertainty. While variable loans may offer lower initial rates, the constant fluctuations can impact long-term financial planning. Ultimately, choosing between fixed and variable depends on individual risk tolerance and financial goals.

Here are some points to consider before deciding which loan type is right for you:

  • Evaluate your financial situation: Can you handle a changing interest rate or do you prefer the stability of a fixed rate?

  • Consider the loan term: Short-term loans might benefit from a variable rate, while long-term loans might be better with a fixed rate.

  • Think about the current economic environment: Are interest rates likely to rise or fall in the future?

INTEREST RATE CAPS

Interest rates significantly impact property affordability. We’ve seen interest rates jump from 3% to over 9% over the past twenty months. If people didn’t have interest rate caps in place for variable interest rates, there’s almost no way a property can survive that. On a small scale let’s look at my home, which has a 2.37% rate, with a mortgage payment of $6,000, if that were to jump up to say 7% that would now be a $13,000 mortgage payment. Insurance products like interest rate caps mitigate this risk because they will pay anything above the cap rate purchased, but they’ve become exceedingly expensive due to rising interest rates. So if someone were to buy an interest rate cap for 5% back in 2020-2021 it cost around $27,000 for an average-size multifamily deal. However, if someone were to buy that same 5% rate cap now in 2024, the price for that insurance is around $900,000. It’s astronomical because of the increase in interest rates. Despite their cost, caps provide security against interest rate hikes for a certain period, typically three years. An interest rate cap is essentially insurance, saying someone else will pay the difference when the interest rate exceeds a certain amount for that set period of time, again usually three years. However, most multifamily deals last for five years to complete the business plan, which then requires paying for an expensive rate cap extension

CONCLUSION

Investment strategies have shifted due to the difficulty in finding good investments. To mitigate risks, fixed-rate loans are favored despite the argument for variable loans during dropping interest rates. The unpredictability of future rates and inflation makes variable loans too risky for some investors, who prefer a lower return with more certainty. This is why Sunrise in Chandler, our new passive investment deal, is on a fixed loan with only around a 6% interest rate. We like fixed loans because they eliminate interest rate volatility.

Yes, we could get a variable-rate loan and an interest-rate cap. However, we would be taking a gamble that interest rates would be lower in three years when the cap expires than they are right now. 

We don’t like to gamble, so we prefer the peace of mind that a fixed-interest rate loan provides. 

The loan-to-value (LTV) is the loan ratio divided by the property’s value, and Sunrise in Chandler is in the low 60s. Meaning that we are putting a 40% down payment. Sure, we could put in a smaller down payment, but it would mean our monthly mortgage payments would be much higher, putting us at risk if rents drop for whatever reason, like a potential recession. 

Alongside the LTV is the debt-service coverage ratio (DSCR). They go hand in hand. The DSCR tells you how much revenue you make compared to the debt. Lenders want you to maintain a ratio of 1.25, meaning you make 1.25x monthly what your debt payments are. Sunrise in Chandler has an amazing day 1 DSCR of 1.61, meaning we make 1.61 for every dollar of debt. Even better, the DSCR goes up every year after that, giving us an extremely healthy buffer between what we make and what we have to spend. These aren’t projections, they’re the actual numbers from how it’s already performing. 

All of these ensure that Sunrise in Chandler has tremendous downside protection and will be able to handle anything the economy throws at it. 

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