How are Interest Rates Determined?

DETERMINING INTEREST RATES

The first question most clients ask, “What is your interest rate?” The question is a good one, but this should come at the end of the conversation rather than at the beginning.

Investment property loans are quite different than primary residence loans. With primary residence loans, the mortgage world uses the concept of “conforming” loans, meaning that loans can be sold into a government-supported program, where most borrowers are lumped into the same large “bucket”. Most mortgage officers simply quote the standard interest rate for the “bucket”, with 30-year conforming being the most common. Primary residence lenders have very little leeway to offer flexibility to clients whose needs do not match the guidelines. On the other hand, investment property lenders rarely use the “bucket” system. Each loan is looked at individually. Each interest rate is specific to the loan. Investment property lenders and their clients understand that there are other concerns (such as length of time to close or length of term) that may make the interest rate a lower priority.

Lenders prioritize different aspects of the loan profile when determining interest rates. Like all good lenders think about risk first. Though no one begins a lending contract thinking about having to foreclose on a property, it is acting responsibly to consider what could be recover in the case of having to foreclose on a property in the worst possible conditions. This leads to the following, in rough order of priority:

1. Loan-to-value (LTV) and spread of the loan

2. Location of the property

3. Type of property

4. Condition of property

5. Occupancy of property

6. Credit history of borrower

LOAN-TO-VALUE RATIO (LTV) AND SPREAD

Loan-to-Value, commonly referenced as LTV, is the most important measure of risk for a loan. It measures the amount borrowed relative to the property value. A closely related concept is “spread”, which measures the dollar difference between the value of the property and the loan size.

A $50,000 loan on a $100,000 property has an LTV of 50% ($50,000/$100,000) and a spread of $50,000 ($100,000-$50,000).

A $300,000 loan on a $500,000 property has a higher 60% LTV ($300,000/$500,000), but also has a higher cushion with $200,000 of spread ($500,000-$300,000).

All else being equal, the general rule of thumb is higher interest rates as LTVs increase and as spreads decrease.

LOCATION

Location, location, location. Very overused, but very true. A decent house in the nicest neighborhoods would always likely to have reasonable value even during a downturn. The same house a couple hundred miles west in the middle of boom-and-bust oil country may be almost impossible to sell during an oil downturn but would be worth a fortune at the peak. The same house moved to a dangerous neighborhood in decay would be nearly impossible to sell at any price.

Thus, the better the location, the more willing we are to make the loan, and the better the interest rate offered.

TYPE OF PROPERTY

This is typically grouped into one of four risk categories:

1. Investment residential and prime retail/office space

2. Warehouse, mixed use, and non-prime retail

3. Industrial and special use

4. Vacant land

These group rankings reflect how quickly the properties could be sold or rented in the unfortunate event that it has to be foreclosed. There is a lower percentage of lenders who loans against vacant land because these properties decline the most during economic downturns. Typically asking for a lower LTV to secure these due to that reason.

A lower group number equates to a lower interest rate.

CONDITION OF THE PROPERTY

It surprises many that the condition of the property falls this low on our list. It is important, but as long as the buildings are structurally sound, cosmetics are not so difficult to improve. Lenders care most about the quality of the roof because water damaged properties are rarely salvageable. Also, considering how the condition of the property impacts the ability of the property to be usable. An office building with collapsing ceilings is unlikely to attract new tenants.

Not surprisingly, the better the condition, the lower the interest rate.

OCCUPANCY

Occupancy may be rented, owner-occupied, or vacant (or some combination). It is preferred to be rented because there are immediate cash flows in the case if it ever had to foreclose. However, it's more common to make loans for owner-occupied commercial buildings (this is not applied in regards to owner-occupied residential) and vacant properties because these properties are difficult to finance through traditional banks.

Rented properties receive the best interest rates.

CREDIT HISTORY

Clients often ask why there is so much care about credit history at all when it's primarily loaning against the value of the property. The care is because of having to foreclose on people. The time and effort into the process as well as having almost no financial upside because the property gets sold at auction to pay us off. Additionally, a bankruptcy filing often stops continuous receiving payments for many months. The credit history helps determine the likelihood that would need to foreclose or that the borrower might declare bankruptcy.

Risk analysis of any scenario is the way of determining rate where all variables are a factor into it. Higher risk will increase the rate, while lower risk will result in favorable ones.