The current interest rate environment facing the commercial real estate industry has caused uncertainty in the financial markets. Oftentimes, our clients feel paralyzed because rates are much higher than at any time in recent memory, but those rates likely face upward pressure in the near term.
HUD vs. Conventional
With rates at levels not seen in over a decade, we compared a hypothetical refinancing of a property using an FHA loan vs. a conventional 10-year loan when the industry experienced a rate spike in the fall of 2013, similar to what we are seeing today. That comparison helped to demonstrate the flexibility and power of utilizing FHA financing. This advantage is especially pronounced when overall rates are elevated compared to historical trends.
For our hypothetical case study, we focused on the refinance of a $10 million property in September 2013 using both an FHA loan and a conventional 10-year term/30-year amortization loan. For the purposes of this study, we kept the loan amounts the same between the two loan programs.
The advantages of the FHA loan proved out as rates declined and then increased again recently as the conventional loan approaches its 10-year maturity date.
The benefits of a HUD-insured loan in this test case are clear. Payments are similar initially between the two loans. In our case study, the FHA borrower had the ability to drop their interest rate by nearly 1% just three years into the loan term at virtually no cost. This adjustment saved the borrower over $600,000 in interest and MIP payments versus the conventional loan (with no MIP) over the first 10 years.
While these results are meaningful, possibly the most important feature of an FHA loan is full term amortization. This feature allows a borrower to do nothing when rates are elevated. The FHA loan continues to amortize over the original 35-year term at the new low rate and the borrower can wait to refinance until the interest rate environment is favorable. With the conventional loan in our example, a financing decision will need to be made inside of the next year with a new interest rate, resulting in substantially higher debt costs and more stringent underwriting requirements.
While this test case is a hypothetical scenario, it is based on actual data and similar loans. The test case highlights the flexibility afforded by an FHA loan that allows borrowers to create significant cost savings for themselves, even if the original loan begins in a high interest rate environment. The last decade brought us several rate cycles and our clients could choose to reduce their rates at any of the dips. The benefits of an FHA loan compared to a conventional loan should be taken into serious consideration as borrowers plan for the future success of their property and investment goals.