When you look to make a real estate purchase for your business you will be confronted with a number of financing options.
One of the options that has made the most headlines recently is the adjustable rate mortgage, or ARM. Despite the bad press, an ARM in and of itself is not necessarily a bad thing. It is important, however, that you understand the general features and situations where an ARM can be helpful.
ARM Rates: Index Based
The first thing to understand is that an ARM will adjust based on an index such as the prime interest rate or the London Interbank Offered Rate, or LIBOR. A simple example would be an ARM that is based on being a few percentage points above LIBOR. The spread between LIBOR and your rate is commonly referred to as the margin. This spread gives the bank some cushion to make profit on the loan. Depending on your credit risk, you may get quoted different spreads.
When you are looking at an ARM you should figure out how often the rate will re-set to the index. For example, you could have an ARM that is quoted as LIBOR +3%, resetting annually. In other words, on a specified date each year your rate will be re-set to whatever LIBOR is at the time, plus the margin of 3%.
Payment Caps and Rate Caps
Many loans will offer payment caps or rate caps to help you manage your payments and ensure that you don't experience an enormous jump. These two features are very different, however. A rate cap will actually cap the interest rate on the high end to ensure you can't be charged over a certain amount. A 12% cap on the example above would mean that once LIBOR goes above 9% (which means you pay 9%+ 3% or 12%) your rate does not continue to increase. You remain at 12% overall until LIBOR goes back under 9%.
A payment cap, however, allows the interest rate to go as high as the rates go. When the payment is capped you may experience some negative amortization. This means that your payment is not enough to cover the interest and principal on the loan and so your loan balance will increase rather than decrease each month. Payment caps without rate caps can be very dangerous, and you should be aware of them before entering into any loan.
Why ARMS work for lenders
Lenders experience two kinds of risk associated with the rate they offer you on a loan. They experience interest rate risk and prepayment risk. An ARM helps the lender to address both of these risks. You will not have the incentive to prepay (via re-financing) if your interest rate adjusts frequently. You will always be paying at a rate that is similar to the rate you experience in the market-place. Second, the lender can avoid losing money by offering you a fixed rate and then seeing interest rates increase in the market place.
Why ARMS work for borrowers
As a borrower an ARM should offer a slightly lower cost of financing up-front than a fixed rate loan. A fixed rate loan requires you to either pay points or some costs up front to compensate the lender for the interest rate and prepayment risk described above. With the proper planning and the right fundamentals, an ARM could be the right answer for you on your next real estate purchase.