For both new and experienced investors, the commercial loan diligence and closing process can be stressful, and the last thing any borrower wants to think about is their interest rate increasing between submitting their loan application and closing. However, there are several factors that can lead to an interest rate change before the loan closes, which can not only affect investor returns, but potentially down payments if the change is drastic enough. The 5 most common reasons an interest rate increase can happen are the following:
1. Early interest rate lock not available or not selected
One of the easiest ways to protect yourself from interest rate increases is to lock the interest rate before closing. Locks (if available) can freeze the rate for up to 6 months, depending on the loan product. However, sometimes this option isn’t available or is too expensive, leaving the borrower to the mercy of the economy until their loan closes.
2. Index rate or spread changes
Most interest rates are based on a combination of an index (i.e. US treasuries, LIBOR, Federal Home Loan Bank rate, etc.) and a “spread” (what the bank/note holder makes as a return), which can change based on demand for a specific loan type. Any increase in either one of these components can increase the overall rate for the borrower.
3. Property cash flow changes
When a lenders offers an interest rate on a property, it is based on specific underwriting parameters and guidelines, including a debt service coverage ratio and potentially debt yield , both of which rely upon the property’s net operating income. If the property income decreases or the expenses increase, the NOI will go down, making both the DSCR and debt yield go down as well. This changes the property’s risk profile, which can result in an interest rate adjustment upwards.
4. Appraisal comes back low or takes too long to get back
There are some facets of the due diligence process that the borrower cannot control, including the third party reports. So if those reports take an extended time to get back or come back unfavorably, the rates can go up. Additionally, although an investor may be paying a specific price for a property, an appraiser may think it is worth something different. An appraiser determines the value of the property based upon comparable properties in the area, the replacement cost of the property, and capitalization rates. If you are one of the unfortunate people that get an appraisal back that is lower than what you are paying for the property, your rate could go up or the bank could require a higher down payment to keep the rate the same (assuming you don’t want to start over again with a new lender).
5. You don’t get your diligence items in quickly enough
If you are not rate locked (or the rate lock expires) while you are executing and providing all of your forms, reports, and other diligence to the lender, your rate can go up. This is especially true if it takes you a long time to do so, and unlike the other 4 reasons your rate could go up, this would be no one’s fault but your own.