What is an Adjustable-Rate Mortgage (ARM)?

Adjustable-Rate Mortgage
March 12, 2021

Adjustable-rate commercial mortgages (also called floating rate mortgages) are the same as residential adjustable-rate mortgages in the sense that the interest rate is adjusted periodically based on a set index. The rates can go up or down over the life of the loan, depending on index conditions.

Interest rates are fixed during the initial rate period (the first few years of the loan) but change based on the movements of the index afterward. These changes or adjustments can be made every year, every three years, or every five years, depending on the agreed-upon adjustment interval.

The indices used to determine interest rates include the COFI or Cost of Fund Index, the LIBOR or London Interbank Offered Rate, and the CMT or Constant Maturity Treasury. The new interest rate is computed by adding a margin (a few percentage points) to the index rate.

Let’s say that the current one-month LIBOR rate is set at 3%. The commercial mortgage lender determines that adjustable-rate commercial mortgages for certain risk sets should be given a 0.50% margin (50 basis points) above the index. This means that the interest rate for that period is adjusted to 3.5%.

Q1: What are the benefits of using an adjustable-rate commercial mortgage?

  • Because of the low-interest rates during the beginning of the loan, your monthly payments will likely be low, too. In some cases, the amount you have to pay monthly can be equal to or even less than your business is paying to rent or lease your commercial space.
  • In theory, you can purchase a larger piece of commercial property for your business because of the low-interest rate. If you’re an investor, you may be able to purchase a larger commercial property asset to rent out. An adjustable-rate commercial mortgage will make you more cash, in this case.

Q2: What are the disadvantages of using an adjustable-rate mortgage to fund a commercial property purchase?

  • This type of mortgage is beneficial when interest rates are low, but not when they start to rise—which eventually happens. In fact, adjustable-rate commercial mortgages are quite risky in the sense that they become costly when rates increase exponentially.
  • If you run a business, it can also be difficult to do proper budget forecasting because you constantly have to adjust rates and predict your monthly payments.

Q3: Can you switch from adjustable to a fixed rate?

Yes. You can choose to refinance your mortgage and switch to a fixed rate. Do keep in mind; however, that refinancing requires closing costs, lender fees, appraisals, and other such expenses.

Is refinancing worth it? That really depends on your plans. Experts agree that if you intend to hold on to your commercial real estate asset for many years, the benefits of refinancing can outweigh its costs.

Let’s say that you have a $1M commercial mortgage and compare the payments you would make on an adjustable SBA 7a loan vs. the payments you would make on a fixed-rate loan.

If you took out an adjustable-rate SBA 7a loan in 2017 based on a 2.25% margin on the Prime Rate (then set at 3.75%), your initial interest rate would have been 6%.

However, in 2019, the prime rate was at 5.5%–which means that you would have adjusted your interest rate to 7.75% in two years. This translates to a significant increase in monthly payments in a short time. You would have had to pay $1,262 more per month.

Whether or not you should refinance really depends on your situation and your long- and short-term goals. Rates are low for now, but it’s important to be cautious if you are sitting on debt tied to an adjustable-rate commercial mortgage.

A low-interest-rate environment can’t last forever. Rates will inevitably rise again, so make sure that you are prudent. Consider talking to a financial or mortgage advisor for guidance.

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