A Quick Explanation for Understanding Loan Terms

When considering an investment property loan from an institutional lender, you need to consider many of the variables involved in the loan terms being offered.

Interest Rate

The cost of borrowing money, i.e., the interest rate, is one of the most important factors. Interest rates affect monthly payments, which in turn affects how much you can afford to pay for a property. It may also affect cash flow, which affects your decision to hold or sell a property.

Loan Amortization

There are many different ways a loan can be structured as far as Simple interest and Amortized. A simple interest loan is calculated by multiplying the loan balance by the interest rate. So, for example, a $100,000 loan at 12% interest would be $1,000.00 per month. The payments here, of course, represent interest–only, so the principal amount of the loan does not change.

An amortized loan is slightly more involved. The actual mathematical formula is complex, so it requires a calculator. The amortization method breaks down payments over a number of years, with the payment remaining constant each month. However, the interest is calculated on the remaining balance, so the amount of each monthly payment that accounts for principal and interest changes. For the most part, the more payments you make, the more you decrease the amount of principal (the amount of the loan still left to pay) owed.

Balloon Mortgage

A balloon is a premature end to a loan’s life. For example, a loan could call for interest-only payments for three years, then be due in full at the end of three years. Or, a loan could be amortized over 30 years, with the principal balance remaining due in five years. When the loan balloon payment becomes due, the borrower must pay the full amount or face foreclosure.

With interest rates uncertain in the future, many lenders are offering variable–rate financing. Known as an “ARM” loan (adjustable rate mortgage), there are dozens of variations to suit the lender’s profit motives and borrower’s needs. ARM loans have two limits (“caps”) on the rate increase. One cap regulates the limit on interest rate increases over the life of the loan; the other limits the amount the interest rate can be increased at a time. For example, if the initial rate is 6%, it may have a lifetime cap of 11% and a one–time cap of 2%. The adjustments are made monthly, every six months, once a year or every few years, depending upon the “index the ARM loan is based.” An index is an outside source that can be determined by formulas, such as:

• “LIBOR” (London Interbank Offered Rate) – based on the interest rate at which international banks lend and borrow funds in the London Interbank market.

• “COFI” (Cost of Funds Index) – based on the 11th District’s Federal Home Loan Bank of San Francisco. These loans often adjust on a monthly basis, which can make bookkeeping a real headache!

• T–bills Index – this is based on average rates the Federal government pays on U.S. treasury bills. Also known as the Treasury Constant Maturity or “TCM,” these are the rates banks are paying on six month CDs.

Sometimes when you are a brand new investor, having a trusted advisor, mentor or a real estate attorney available to answer your questions just might be a great investment!