There are two ways to explain a take-out loan and one explanation is that their main function is to take-out or replace an existing short-term loan. This usually happens when property investors take short-term construction loans to erect commercial buildings after which they then mortgage the completed property, which is now ready to generate returns.
Another way to explain a take-out loan is that it is a loan mostly used for the purchase or to mortgage commercial real property in order to realize the full value of the property. Take-out loans usually have fixed monthly payments that cover both the principal and the interest payments, that is, they are amortized.
How a take-out loan works
Most experts agree that the main function of a take-out loan is to replace existing short-term loans, which are usually characterized by high interest rates. The take-out loan is usually a long-term mortgage with a lower interest rate because it is typically secured by an income-generating commercial property, which presents a lower risk of default.
In most cases, property investors will use a take-out loan to pay off construction loans, which are usually short-term and attract high interest rates, because the construction site has minimal value until the building is completed and fully occupied.
Personal take-out loans
Although take-out loans are mostly used by property investors for commercial buildings, individuals can also apply for and receive personal take-out loans. Individuals can use personal take-out loans to settle their current outstanding loans issued by other creditors. This is a good form of debt consolidation where the individual will be left servicing just one long-term take-out loan with favorable interest rates and a fixed monthly payment. This saves the individual from servicing numerous short-term loans with high interest rates from different creditors.
Unique characteristics
Most investors prefer take-out loans to short-term loans due to their long-term maturity and their favorable interest rates. However, some take-out lenders may offer very low interest rates in exchange for a portion of the profits (capital gains) on the property when the investor sells it. Other lenders may request the borrower to pay them a portion of the income, which in this case is rents, generated by the property.
Example of a take-out loan
Let’s assume that a construction company wants to erect a commercial building in midtown. It approaches a lender for a short-term loan in order to meet the construction costs. The lender(A) awards the company a short-term construction loan of $6 million payable in 2 years at10% interest. The company uses the loan to complete construction in 20 months.
Having completed construction and opened the building for occupation, the construction company can now approach a new lender for a take-out loan to settle the construction loan. The lender (B) awards the company a $6 million take-out loan secured by the operational building payable in 15 years at 5% interest. The company can now settle the construction loan and comfortably pay off the take-out loan with favorable terms.
Take-out Loans Vs. Standard Loans
Take-out loans are typically used as a replacement to standard loans. Take-out loans generally have higher interest rates and more burdensome terms than standard mortgages. In many instances a borrower may utilize a take-out loan when they cannot qualify for a traditional loan or do not have the necessary time to qualify for a standard mortgage. In instances like these it may be worth it for the buyer or owner to pay a higher interest rate to get the mortgage they need. Take-out loans are usually not the preferred method of most borrowers because of the increased cost of borrowing compared to standard loans.
