Written by Matthew B. Gunter, Esq., Attorney, Lightning Docs
In the recent economic environment of rising rates and inflation, fixed interest rate loans, which are simple, easy to calculate, and provide a predictable future income stream, can result in diminishing returns to the lender in the form of opportunity costs, reduced purchasing power of the money paid, and lower margins compared against a lender’s own cost of funds.
A variable rate, on the other hand, is simply a mechanism that allows the note interest rate to increase or decrease at set intervals based on how the broader financial market or economy is performing. There are many ways to structure the variation in the rate, and choices in what to base the changes. This article explores the basics in variable rate mechanics, the “indexes” used for interval changes, and other considerations you must understand before computing interest in this way. This article should not be understood as making any finance or planning recommendations.
What does a variable rate do for me?
Many lenders find themselves borrowing money from warehouse lines or other finance providers in order to re-lend that money to their own borrowers. Warehouse lines themselves typically have variable rates of interest. If your own borrowing costs rise as a result of an adjusted interest rate, it makes sense to pass on those costs to your own borrower if you wish to keep your earnings stable. Likewise, you could reward your borrower with lower costs in the event your costs decrease. In either scenario the variable rate stabilizes the rate of return to the lender by matching the lender’s increasing borrowing costs with increasing income from their borrower’s interest payments.
In addition to borrowing costs, opportunity costs change as rates do. Imagine lending $100,000 for a year at 5% today when one month from now you could have made the same loan at 6%. That is a $1,000 difference. If market rates are expected to rise, opportunity costs rise as well when using a fixed rate. The variable rate allows you to capture the higher rate as they rise. The opposite is also true, however, so in an environment where rates are expected to decrease, a fixed rate, even for a defined period, may be a better option.
How can the variable rate be structured?
Defining how the variable rate will work can range from simplistic to complex and is highly flexible. The following are only but a few of the options available to you. Most commonly you will wish to define:
- The index / benchmark
- Margin
- Fixed Period (if any)
- Adjustment Interval
- Initial Rate
- Initial Change Limit
- Recurring Change Limit
- Maximum Rate
- Floor Rate
The index or benchmark is the publicly available interest rate data based on aggregate rates from a variety of sources. The change in these rates causes the change in your rate. Further information about benchmarks and indexes follow in the next section.
The margin is the percentage above the benchmark you wish to maintain generally as your interest rate. For example, if the index is at 2.4% today and you have a 1.5% margin, that means you are charging 3.9% to your borrower. If the index increases to 2.6% then the interest your borrower pays increases by the same amount to 4.1%.
The adjustment interval is the amount of time between the change in the interest rate. The date or time the interest rate changes is often termed the “Change Date”. The Change Date can be as often as daily and as infrequent as annually or longer. The most common is on the first day of each month.
The fixed period, if you choose to use one, is the period of time that the rate is to remain fixed and unchanging. This is essentially a hybrid approach, allowing a fixed interest rate for a period of time, then employing a variable rate thereafter.
The initial rate is the exact interest rate that will be utilized until the first Change Date. This is typically tied to the current index on or around the closing date, but it does not need to be.
The initial change limit, if you choose to use one, is the limitation on the size of the change in rate from the initial rate on the first Change Date. The recurring change limit, again if you choose to use one, is the limitation on the size of the change in rate on each successive Change Date. For example, if the index is at 2.6% today and the margin is 4%, the borrower is paying a rate of 6.6%. If there is a 1% change limit then even if the index spikes to 5% at the time of the next Change Date and the borrower would otherwise be expected to pay a 9% interest rate, the change limit reduces the effective interest rate to 7.6%; which is only 1% higher than the prior rate.
The maximum rate and the floor rate are the highest and lowest rates, respectively, that a borrower will be expected to pay, notwithstanding the foregoing calculations. The maximum rate is particularly important in considering usury limitations, and the floor rate protects the bottom line for lenders who choose to have a minimum expected return.
What indexes and benchmarks can I use?
While there are literally hundreds to choose from, there are about 5 or 6 that are typical and some of these few are themselves the vast majority. Generally lenders choose from the following, including some variations on these:
- LIBOR (London Inter-Bank Offered Rate)
- SOFR (Secured Overnight Financing Rate)
- Wall Street Journal Prime
- 30-Year U.S. Treasury
LIBOR had been ubiquitous until a fraud scandal several years ago tarnished its image. Many larger banks and lending institutions have moved away from LIBOR in favor of SOFR. LIBOR is being phased out in the U.S. and publication of its rates are to be halted, so use of this index is not favored.
SOFR is based upon the interest rates banks pay to repurchase treasury bonds. SOFR is very sensitive to changes in the Federal Reserve’s “Federal Funds” rate – the rate that has been infamously rising for the last year to combat inflation, though other factors influence as well, particularly banks’ needs for liquidity at ends of financial quarters and years, causing temporary spikes.
Wall Street Journal Prime, often simply called the “Prime Rate”, is also highly sensitive to the Federal Funds rate but is also measured by what banks charge their most creditworthy customers. The Prime Rate as published in the Wall Street Journal is the average rate amongst many banks. As the Federal Funds Rate increases or decreases, so does the Prime Rate, though the amount may be different based upon the average interest charge to these creditworthy customers. Generally, in worse economic conditions, creditworthiness worsens which tends to push the rate higher.
The US Treasury debt obligation as an index is commonly used by looking at the 30-year constant maturity variety, though other maturity periods as well as inflation adjusted versions are also available. Treasuries are sensitive to the Federal Funds Rate which moves infrequently but in relatively large steps, but also sensitive on a daily basis to investor demand for the treasuries themselves, but in relatively small amounts. As the Federal Funds rate rises, as it has been recently, the rate (yield) on treasuries rise. As the demand for treasuries increase, however, it pushes down the rate.
Additional Considerations
One of the most important considerations when using a variable rate is usury – the maximum interest rate permissible under a particular state’s law. When rates are allowed to fluctuate, what one day may be permissible interest may then jump higher than the legal limit, the next. Setting a maximum rate at or below the usury limit is the safest way to protect against claims of usury.
Many of the indexes that can be selected have variants which show either daily movement or represent an average of daily movements over a set time period, often 30 days or more. When rates are expected to rise, Lenders may wish to have an index variant showing shorter interval averages or simply the daily movement as this will more likely capture the high point in the rate on the succeeding rate-change dates – as opposed to an average which will factor in the lower rates that preceded the rate-change date. Of course, the opposite is also true in an environment where ratees are expected to decrease. US Treasuries, specifically, are most volatile on the shortest maturities where the Federal Funds Rate changes affect the rate significantly, but much less volatile on the 30-year variety which averages out the Federal Funds rate expectations over that time period.
From a practical standpoint, lenders should ensure that the servicer or servicing software is up to the task of handling a variable rate, particularly if the intervals for change are shorter than one month. An inability to accommodate a variable interest rate will prevent it from being used.
Title insurance insures the enforceability and priority of a security instrument (Mortgage, DOT, etc.) generally, but extra protection is available through an ALTA 6 endorsement which specifically covers invalidity, unenforceability, or loss of priority as a result of having a variable rate.
Concluding thoughts
A fixed interest rate means that you will be receiving the same amount of money at every payment. Easy, simple, but problematic if you yourself owe money at higher and higher rates in an inflationary financial market.
Using a variable rate goes a long way to solving those problems, depending on how it is structured. Much of what goes in to deciding to use a variable rate in the first place is having an educated guess as to whether market-rates will be increasing or decreasing on average over the life of the loan and the magnitude of those changes.
There are many choices to consider and no two loans should be treated the same. Geraci’s Banking and Finance attorneys have many years of experience to be able to guide Lenders through the decision process, as well as to create the loan documents that support and enforce these variable rates. Please reach out with any questions, concerns, or comments.
