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Floating Rate versus Fixed Rate Planning Example

We all know that the interest rates for borrowing vary among the institutions and firms making the loans and that many factors go into their analysis of factors including the borrower’s ability to pay, access to security for the loan, nature of the project funded by the loan and so on. A client came up with a slightly different slant on the issue when he decided to seek financing to build a new residence that he plans to occupy with his family. Although short on liquidity necessary to fund the project, this client had substantial resources and cash flows which could be used in connection with the construction project and acquisition of the new home.
A major issue for this client turned out to be a question whether it would be better to obtain an interest only loan using trust assets for security and subject to a currently low floating rate or to use different assets and obtain a fixed-rate mortgage for the project. As you can imagine, there are pros and cons to each of the approaches and the client needed to make an informed decision as to what would be best, given his financial situation. 
The floating rate loan would be appealing so long as the interest rate did not increase very much or very quickly – its advantage over the fixed rate could be lost over time and end up costing the borrower more in interest when the rate rose. This loan would be useful to fund construction over the near term at the low rate and interest only terms would keep the cost down during that process. The low interest rate was very attractive to the client as well. However, ultimately the principal balance would become due and require the client to obtain replacement funding or tap other resources.
The fixed rate loan, though initially at a higher rate than the floating rate loan, could easily become competitive over time as interest rates in general increase while this loan rate remains unchanged. This approach also would keep the trust assets out of the equation and permit their use for other purposes if necessary. Finally, the fixed rate loan would require larger payments as the principal balance of the loan would need to be reduced over time in addition to the payment of interest.
Both options would permit the client to deduct a portion of the mortgage interest, although the amount of the loan deductible would be capped under the new tax law. Given all these factors, perhaps the best approach for this client would be to obtain the floating rate loan to finance construction and then, with the building completed, pay off the floating rate loan using fixed financing with the finished structure as security. This would permit the client to benefit from the low interest rate over the near term and the fixed rate over time as interest rates likely rise. Although this step approach might not work for everyone, it allows the client the best of both worlds and keeps some flexibility in the transaction.


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