Higher rates are not only an issue for the buyer. Due to the higher rates, sellers will find that the value of their property, although at an all time high in the revenue they are generating, may have a lower value due the funds required to cover the debt service. The point is the increase in interest rates is having an impact on inflation.
We compare strategies for getting the best residential mortgage rate to best practices for commercial B&B inn buyers. Our goal is to point out the similarities, as well as differences, between a residential mortgage and a commercial bed & breakfast inn mortgage. Moreover, how you should address these issues to ensure you obtain the best rate available.
First Some Definitions
Small Business Administration (SBA)
A government agency that provides insurance to lending institutions who make loans to insure the people who desire to own their own, and have access to capital to purchase a small business.
Debt-to-Income (DTI) Ratio
This is simply a formula that the banks use to confirm the funds available from the net operating income are sufficient to cover the debt ratio. Normally this is the total of the annual monthly payments multiplied by a factor of 1.25—1.30. We normally use 1.25 in our calculations.
The primary loan a bank makes to a buyer is called the 1st Mortgage. Sometimes the seller will also offer a mortgage behind a 1st mortgage, thus the name “2nd Mortgage”. Sometimes this is done to ensure there is sufficient investment from the buyer & the seller to satisfy the requirements of the lending institution.
Lower mortgage rates may be on your mind if you're thinking about buying a property right now. Mortgage rates have been steadily rising amid inflationary pressures and economic uncertainty. Even the experts are divided when it comes to predicting where rates are headed next. (1)
This climate has been unsettling for some homebuyers and sellers. However, with proper planning, you can work toward qualifying for the best mortgage rates available today – and open up the possibility of refinancing at a lower rate in the future.
Best Mortgage Rate
Getting the best mortgage rates may be on your mind if you’re thinking about buying a 2nd home or a commercial Bed & Breakfast Inn. Mortgage rates have been on a steady increase for the majority of the year. Currently, it appears there is a high likelihood that we will have 1-2 more increases in 2022 to attempt to slow down inflation. Even the experts are divided when it comes to predicting where the rates are headed next. However, most expect 1-2 more increases in interest rates this year.
How does a lower mortgage rate save you money? According to Trading Economics, the average new mortgage size in the United States is currently around $410,000. (2) Let’s compare a 5.0% versus a 6.0% fixed-interest rate on that amount over a 30-year term.
With a 5% rate, your monthly payments would be about $2,201. At 6%, those payments would jump to $2,458, or around $257 more. That adds up to a difference of almost $92,600 over the lifetime of the loan. In other words, shaving off just one percentage point on your mortgage rate for your inn could put nearly $100K in your pocket over time.
So, how can you improve your chances of securing a lower mortgage rate? Try these 7 strategies.
Residential Strategy #1:
Raise Your Credit Score
Borrowers with higher credit scores are viewed as “less risky” to lenders, so they are offered lower interest rates. A good credit score typically starts at 690 and can move up into the 800s. (3) If you don’t know your score, check with your bank or credit card company to see if they offer free access.
If not, there are a plethora of both free and paid credit monitoring services you can utilize. If your credit score is low, you can take steps to improve it, including: (4)
- Correct any errors on your credit reports, which can bring down your score. You can access reports for free by visiting AnnualCreditReport.com.
- Pay down revolving debt. This includes credit card balances and home equity lines of credit.
- Avoid closing old credit card accounts in good standing. It could lower your score by shortening your credit history and shrinking your total available credit.
- Make all future payments on time. Payment history is a primary factor in determining your credit score, so make it a priority.
- Limit your credit applications to avoid having your score dinged by too many inquiries. If you’re shopping around for a car loan or mortgage, minimize the impact by limiting your applications to a short period, usually 14 to 45 days. (5)
Over time, you should start to see your credit score climb — which will help you qualify for a lower mortgage rate.
Residential Strategy #2:
Lower Your Debt-to-Income Ratios
Even with a high credit score and a great job, lenders will be concerned if your debt payments consume too much of your income. That’s where your debt-to-income (DTI) ratios will come into play.
There are two types of DTI ratios: (6)
1.Front-end ratio — What percentage of your gross monthly income will go towards covering housing expenses (mortgage, taxes, insurance, and dues or association fees)?
2.Back-end ratio — What percentage of your gross monthly income will go towards covering ALL debt obligations (housing expenses, credit cards, student loans, and other debt)?
What’s considered a good DTI ratio? For better rates, lenders typically want to see a front-end DTI ratio no higher than 28% and a back-end ratio that’s 36% or less. (6)
If your DTI ratios are higher, you can take steps to lower them, like purchasing a less expensive home or increasing your down payment. Your back-end ratio can also be decreased by paying down your existing debt. A bump in your monthly income will also reduce your DTI ratios.
Residential Strategy #3: Increase Your Down Payment
Minimum down payment requirements vary by loan type. But, in some cases, you can qualify for a lower mortgage rate if you make a larger down payment. (7)
Why do lenders care about your down payment size? Because borrowers with significant equity in their homes are less likely to default on their mortgages. That’s why conventional lenders often require borrowers to purchase private mortgage insurance (PMI) if they put down less than 20%.
A larger down payment will also lower your borrowing costs and decrease your monthly mortgage payment, since you’ll be taking out a smaller loan. Just be sure to keep enough cash on hand to cover closing costs, moving expenses, and any furniture or other items you’ll need to settle into your new space.
Residential Strategy #4:
Compare Loan Types
All mortgages are not created equal. The loan type you choose could save (or cost) you money, depending on your qualifications and circumstances.
For example, here are several common loan types available in the U.S. today: (8)
- Conventional — These offer lower mortgage rates, but have more stringent credit and down payment requirements than some other types.
- FHA — Backed by the government, these loans are easier to qualify for, but often charge a higher interest rate.
- Specialty — Certain specialty loans, like VA or USDA loans, might be available if you meet specific criteria.
- Jumbo — Mortgages that exceed the local conforming loan limit are subject to stricter requirements and may have higher interest rates and fees. (9)
When considering loan type, you’ll also want to weigh the pros and cons of a fixed-rate versus variable-rate mortgage: (10)
- Fixed rate — With a fixed-rate mortgage, you’re guaranteed to keep the same interest rate for the entire life of the loan. Traditionally, these have been the most popular type of mortgage in the U.S. because they offer stability and predictability.
- Adjustable rate — Adjustable-rate mortgages, or ARMs, have a lower introductory interest rate than fixed-rate mortgages, but the rate can rise after a set period — typically 3 to 10 years.
According to the Mortgage Bankers Association, 10% of American homebuyers are now selecting ARMs, up from just 4% at the start of this year. (11) An ARM might be a good option if you plan to sell your home before the rate resets. However, life is unpredictable, so it’s important to weigh the benefits and risks involved.
Residential Strategy #5:
Shorten Your Mortgage Term
A mortgage term is the length of time your mortgage agreement is in effect. The terms are typically 15, 20, or 30 years. (12) Although most homebuyers choose 30-year terms, if your goal is to minimize the amount you pay in interest, you should crunch the numbers on a 15-year or 20-year mortgage.
With shorter loan terms, the risk of default is less, so lenders typically offer lower interest rates. (12) However, it’s important to note that even though you’ll pay less interest, your mortgage payment will be higher each month, since you’ll be making fewer total payments. So before you agree to a shorter term, make sure you have enough room in your budget to comfortably afford the larger payment.
Residential Strategy #6:
Get Quotes From Multiple Lenders
When shopping for a lower mortgage rate, be sure to solicit quotes from several lenders and lender types to compare interest rates and fees. Depending upon your situation, you could find that one institution offers a better deal for the type of loan and term length you want.
Some borrowers choose to work with a mortgage broker. Like an insurance broker, they can help you gather quotes and find the best rate. However, if you use a broker, make sure you understand how they are compensated, and contact more than one so you can compare their recommendations and fees. (13)
Don’t forget that we can be a valuable resource in finding a lender, especially if you are new to the inn buying process. After a consultation, we can discuss your financing needs and connect you with loan officers or brokers best suited for your situation.
Residential Strategy #7:
Consider Mortgage Points
Even if you score a great interest rate on your mortgage, you can lower it even further by paying for points. When you buy mortgage points — also known as discount points — you essentially pay your lender an upfront fee in exchange for a lower interest rate.
The cost to purchase a point is 1% of your mortgage amount. For each point you buy, your mortgage rate will decrease by a set amount, typically 0.25%. (14) You’ll need upfront cash to pay for the points, but you can more than make up for the cost of interest savings over time.
However, it only makes sense to buy mortgage points if you plan to stay in the home long enough to recoup the cost. You can determine the breakeven point, or the period of time you’d need to keep the mortgage to make up for the fee, by dividing the cost by the amount saved each month. (14) This can help you determine whether mortgage points would be a good investment for you.
Improving Your Inn's Mortgage Rate
Today’s 30-year fixed rates still fall beneath the historical average of around 8% — and are well below the all-time peak of 18.45% in 1981. (15, 16) Although higher mortgage rates have made it more expensive to finance the purchase of property, they have also eliminated some competition from the market.
Consequently, today’s buyers find more homes to choose from, fewer bidding wars, and more sellers willing to negotiate or offer incentives such as cash toward closing costs or mortgage points.
So you may be better off buying today at a slightly higher rate than waiting and paying more a few years from now. You can always refinance if mortgage rates go down, but you can’t make up for the lost years of equity growth and appreciation.
I remember an investor in stock told me that the "stock" does not know you love it. The same is true with your Inn. You may love your Inn. But the Inn does not know you love it! When the time is right for you go ahead and list it.
B&B Consulting Comparison of Residential Loan to Commercial B&B Inn Loan
The average cost of a bed and breakfast inn is estimated to be greater than $1,000,000. This is 2.5 times greater than the average cost of a private residence. Additionally, the terms and conditions of a residential mortgage and a commercial mortgage is like comparing apples to oranges.
Normally, an owner of a bed and breakfast inn will own the inn for 5+ years prior to placing the property for sale. One of the reasons is the lending institutions will require 3+ years of P & L's and tax returns to support the asking price. This requirement is not mandatory but it is highly recommended.
Improving Your Inn's Mortgage Rate
Unfortunately, the rock-bottom mortgage rates we saw are behind us. Currently a large number, if not the vast majority of Bed & Breakfast Inns are experiencing record bookings and revenue. I like to use the comparison of your Inn’s value as to the value of the stock market. When do you sell your stock? You sell your stock when it is at an all time high. If your Inn’s revenue is at an all time high, why not sell it?
Most likely, if you have owned your property for 5-10 years, you likely have a mortgage rate in 3.5—4.5 % range. Buyers looking to make a purchase today are looking at an interest rate in the 7.5—8.50 % range. Since the payment on your debt is in the 3.5--4.5% range, you are showing an attractive “Return on Your Investment”. However, a buyer who is trying to purchase your property and will now have a mortgage rate in the 7.5—8.5%
range and cannot cover the debt service.
If you are one of the fortunate Inn owners, who happens to have an “Assumable Loan” you should be in favorable positions. However, very few Bed & Breakfast Loans are Assumable. As you know, most folks who have a loan on their Bed & Breakfast Inn have an SBA Loan. Most, if not all, Bed & Breakfast Inns have an SBA Loan. Even if the SBA did approve the loan to be assumed, most banks will not support the assumption because the assumption of the loan has a high likelihood of disqualifying the SBA guarantee on the loan.
If an Inn owner has been in the business 10+ years, there is a high likelihood the Inn owner may have a very small balance on your loan or no balance at all. In the past several years the banks & the SBA would require an injection of funds in the 10% range. Recently we have seen requirements of 30-40% as a down payment. Thus, if the buyer injects 30-40% down they can request owner financing. In years past, this would not have been attractive to sellers because the interest rates were so low.
But in today’s environment, the owner could offer a 1st mortgage of 5.0—5.5 % to the buyer. This is a great deal for both the buyer for the seller. This could be a 5--10 year mortgage, with a balloon. Whatever works for both the buyer and seller.
High Credit Scores Required for Commercial Properties
Federal Reserve Interest Rate Differences
Since we have already discussed the issue of owning the property for more than three years, most likely the conventional and/or SBA loan on the property is in the 3.5% to 4.5% range. If so, great. If it can be "assumed" it is even greater. In fact, it is fantastic!
However, the majority of SBA loans cannot be assumed. This is important due to the Federal Reserve increase in interest rates to fight off inflation. An SBA loan today is in the 7.5% to 8.0% range. Thus, the issue is the difference between an existing loan (in the 3.5% to 4.5% range) and a SBA loan (7.5% to 8.0% range) is almost doubled.
This is a key whether you are a buyer or seller! Make sure you know what you are buying or selling. Is the property a Lifestyle Inn? Is the Property a Viable Property? Do you know the difference? Very important whether you are a buyer or seller.
Due to the current economy, we are finding many Lifestyle properties that are 5-7 bedrooms are more valuable as a Residential property than they are as a Bed & Breakfast Inn. We have sold several Inns over the last few years to residential buyers simply because there is more demand for a 5-7 room private residence than there is for a 5-7 room Bed & Breakfast Inn.
Increasing Your Commercial Property Down Payment
Just like buying a private residence, another strategy is to increase your down payment. The banks and the SBA have already addressed this issue. For the past several years, the banks and SBA have been requesting a 10% down payment.
However, recently, we have seen requirements of 30% to 40% down payments. Sometimes this may be a 20% down by the buyer and 20% owner taking a second mortgage to make the deal work.
A smaller down payment will either cost an exorbitant amount of discount points OR exceed the maximum amount any lender can charge by law. Both of these options are deal-breakers.
Big difference between a 1st Mortgage & a 2nd Mortgage. It is like night and day. With a 1st Mortgage, you have a 1st claim on everything. When you have a 2nd mortgage, you are always behind the 1st Mortgage. There are times when a 2nd mortgage is necessary. You just need to remember that a 2nd mortgage is only as good as the paper it is written on and the person who signs the 2nd Mortgage.
Make sure you know the credit history of your buyer before you agree to a 2nd Mortgage. There is a reason for Credit Scores. Loan money or take a 2nd Mortgage from someone with a poor credit score and you will find out why they have a poor credit score.
When you have a 1st mortgage, and the buyer does not make the payments you can foreclose on the buyer and take back the property. When you have a 2nd mortgage, and the buyer does not make the payments, you can foreclose on the buyer and your 2nd Mortgage is still a 2nd Mortgage, and you remain behind the 1st Mortgage.
The Option to Offer Owner Financing
Depending upon your debt, you may be in a better position to offer owner financing.
As an example, your inn is under contract for $1,500,000. You owe $300,000 on the property. The buyer is paying 30% down ($450,000).
You can pay off your mortgage and you net $150,000 (less other expenses). Now you have a first mortgage you can charge 5%.
This is a good deal for you, the seller, and for your buyer. Plus, you have a first mortgage on the property.
The significant difference in a 1st Mortgage and a 2nd Mortgage is if the buyer defaults you can foreclose and get the property back.
Just like a residential home mortgage, the buyer should consider the following options:
1) Shorten the mortgage term. This will increase the monthly terms, but it will also pay off the loan faster and increase your equity.
2) Get initial quotes from several lenders. You may consider using a broker to ensure you get the best rate. You may be charged 1-3% upfront, but if your interest rate is 1-2 annually less, you are saving significant funds.
3) Considering paying “points”, you can buy down the interest rates.
4) When selecting a mortgage company, ask if they can offer you a loan that is assumable. This could be valuable when you decide to sell your Inn.
Conclusion: Your B&B Inn Mortgage Rate
If you have a question or would like more information about buying or selling a B&B Inn, contact us to schedule a free consultation. We’d love to help you weigh your options, navigate this shifting market and reach your real estate goals.
B&B Consulting is uniquely positioned to help buyers and sellers of B&B Inns. Rob Sales, along with wife Jane, successfully owned & operated several Inns. In addition, he has been a licensed realtor and B&B Consultant for decades.
Innkeepers (and prospective innkeepers) trust Rob to share his wisdom from both the hospitality and the real estate industries. This includes working with the right people to help you secure the best B&B inn mortgage rate that we can. Contact Rob today for a complimentary one-on-one consultation.