The recent news from the Federal Reserve about potential interest rate increases to combat the inflation the economy is currently seeing is making business owners rethink their existing business debt. A question that businesses are considering nowadays is whether or not they should look into locking in variable rate loans they currently have. The answer to that question is, well, it depends. There is no right or wrong answer, it depends on the individual business, its financial status, tolerance of risk by the business owner and the term of the existing loans. Business owners need to consider the benefits and downside of each of the rates.
Floating or variable interest rate loans are driven by the current economic market, they offer a lower cost to the borrower, and the interest rate may increase or decrease over the term of the loan. One key thing to remember is that under a variable rate loan, the borrower bears all the interest rate risk as he or she will be exposed to the risk of rising rates.
Variable rate loans can be more attractive to borrowers since they are typically available at a much lower rate than a fixed rate loan. The variable rate loans are structured based on either Secured Overnight Financing Rate (SOFR) or Bloomberg Short-Term Bank Yield Index (BSBY) plus the spread agreed upon between the lender and the borrower. For example, if the base rate is based on SOFR the interest rate for the month would be SOFR plus spread. If SOFR is currently 0.05 and the point spread is 2.0 (200 points) then the all-in rate for the month will be 2.05%.
Base interest rates tend to rise when the economy is growing too quickly and inflation is going up faster than expected. Base rates tend to stay the same when the economy is growing at a reasonable pace and there is low, manageable inflation. Base rates fall when the economy is weak and financial markets are under pressure.
Fixed interest rate loans have a predetermined interest rate that remains the same over the term of the loan. The interest rate will not go up or down even when base interest rates rise or fall. Fixed rate loans can be more or less cost efficient depending on whether interest rates go up or down. Currently, fixed interest rates are priced at a much higher rate, e.g. 4.00% – 4.25% fixed versus all in rate of 2.05% under a variable rate loan. Lenders bear the interest rate risk (from potential rate increases) therefore they price the fixed rates loans higher in order to compensate for the risk they will be facing. Fixed rates are based on the corresponding term Treasury rate (benchmark for structuring the fixed rate loan) plus the spread agreed upon. For example, if the 10-year Treasury rate is 1.90% and the point spread is 2.00 the total fixed rate will be 3.90%.
Fixed rates are not impacted if interest rates go up and help borrowers manage their cash flow since they know with certainty the payments from the start of the loan until the end of the term.
A potential strategy that borrowers may want to consider is fixing a portion of their loans and leaving the remaining floating. This strategy will allow them to have an interest rate hedge in the current rate environment providing the advantages of both types of rate loans.
So, which type of loan is better, fixed or variable? Well, as we said at the beginning of this article, it depends. To help with making a decision, business owners should consider the following:
- Do you prefer predictable monthly payments that won’t vary over time?
- Do you mind uncertainty in how much you might pay?
- What is your risk tolerance, considering the current and future market conditions?
- What are the terms of the loans, both existing and new loans?
- Is cash flow in your business tight with little room for flexibility?
Unfortunately, deciding between these types of rate loans is not black and white. Ultimately, it comes down to personal preferences, risk tolerance and the business owner’s short-term and long-term goals. We recommend that you consult with your lender directly to discuss your business loans and discuss your options that are specific to your organization.
Nina Daigle, CPA, is a Partner with Antares Group, Inc. She can be reached at email@example.com.