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Understanding Real Estate Interest Rates

Interest Rates in the Real Estate Industry

In borrowing and lending terms, interest rates represent the price to borrow. Essentially, a lender makes a profit from charging an interest rate when a loan is repaid in full, over time. Interest rates also represent the amount of risk a lender is willing to entertain. High interest rates usually mean the lender classifies the loan as high risk, whereas lower interest rates could indicate a lender considers the loan as a low risk. Lenders consider different factors when identifying low vs high risk borrowers. When a lender assigns an interest rate, they justify the terms they are willing to lend on via interest rates. There are four major factors a lender considers when assigning an interest rate to a loan:

  • Length of the loan
  • Loan amount
  • Probability of the borrower defaulting
  • Inflation

A lender will calculate an interest rate using a combination of these factors to determine a satisfactory loan amount for the borrower. On the same token, regardless of the above factors, the Federal Reserve System (FED) controls interest rates at the credit card, banking prime rate and adjustable rate level. Investment decisions are heavily influenced by interest rates because they ultimately affect how much an investment will cost. In real estate, interest rates vary depending on the type of investment you choose. In the following section, we’ll explore how different real estate transactions apply interest rates.

Understanding Interest Rates in Different Types of Real Estate

  • Interest Rates in a Traditional Home Mortgage: In a homeownership real estate transaction, there are usually three major players: the potential homeowner/borrower, the real estate agent or broker, and the lender. When it comes down to interest rates, the borrower can choose between a fixed-rate or adjustable-rate mortgage. Over the lifespan of a loan, a fixed-rate mortgage, will render the same monthly payments till the loan is repaid. The interest rate does not change in this interest rate structure, and repayment options typically fall in the 30, 20, 15, and 10 year lifespans. In an adjustable-rate mortgage, the monthly payments a borrower will pay is subject to change based on changing interest rates. Interest rates can change based on any of the major factors listed above, but in an adjustable-rate mortgage there is usually a cap or maximum number of times an interest rate can change to protect the borrower. In an adjustable-rate mortgage you’ll typically see a lower interest rate for the first few years of the loan, then an increase will set in around 4-5 years in.

  • Private Lender Interest Rates: In private equity and ownership, there are typically high interest rates associated to lending. Private lenders assign higher interest rates because they place less emphasis on a borrower’s credit score (risk of default), and administer a simplified lending process.

  • Interest Rates in REITs: REIT Investors are not seeking loans to purchase shares of REIT stock. Taking out loans and the cost to borrow is usually not a concern for a REIT investor. The rise and decline of interest rates, controlled by the Federal Reserve System (FED), affects REIT investors and the amount of income produced from a REIT. So, historically, when interest rates have risen, RIET prices have declined. As a result, current stock prices were worth less. So to increase yields, prices had to fall.

  • Crowdfunding Interest Rates: Like REIT investors, real estate crowd-funders typically do not seek out loans. They too, are not concerned with cost to borrow interest rates. Crowdfunding platforms include many financiers, quick turnover time, far less regulatory standards to abide by, and rates that remain constant compared to banks. As a result, crowdfunding investors typically do not feel the repercussions of rising interest rates in the short-term.

  • Home Equity & Line of Credit Interest Rates: Like a traditional homeownership mortgage, home equity loans can include various interest rate structures. Whether if it is fixed, variable or adjustable rate you choose, it is crucial that you do your homework for the best or lowest rate.

  • Commercial Loan Mortgage Interest Rates: Typically obtained by companies, rather than by individuals, commercial loans and mortgages tend to have 2% higher interest rates when compared to home loans. Higher interest rates can be attributed to the difficulty banks face determining credit worthiness of a business versus an individual. In addition, a company’s commercial mortgage payment may come from tenant rental fees. In this case, a commercial versus residential loan is a higher risk. Higher risks warrant higher loan interest rates. So for this exmaple, an owner depending on rental income vs a homeowner depending on employment pay checks to pay the mortgage is more of a risk.

In Summary

Interest rates have a large impact on real estate investments. The cost to borrow is usually a relevant factor regardless if you’re seeking a loan to purchase a property or investing your money in a project through crowdfunding or REIT stock. Your investment strategy and goals are the most important components in a real estate investment. Knowing the market, and understanding how interest rates will affect your investment are crucial as well. In addition, selecting the best interest rate structure can be tricky if you are seeking funding for an investment. If you are interested in investing in real estate, you should keep up to date with the Fed’s interest rate news and follow housing market news. If you are interested in learning more about interest rates, contact CityVest today.

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