Imagine buying a newly issued bond from the U.S. Treasury (“UST”) today. If you did, you’d earn 1.27% per year for the next 10-years. Hard to imagine. After you factor in inflation, you would probably be losing money! In fact, at the beginning of this year, the rate on a 10-Year UST stood at less than 1%. By mid-March, that rate had risen to 1.7% only to then pull back to its current level.
This extremely low interest rate environment has many business owners wondering about their own debt and asking, “When I’m taking out or refinancing a loan, should I be considering a fixed rate or floating rate?” It’s definitely a tough call and we wanted to provide some thoughts and insight.
- There is very good reason to think that locking in a fixed rate in today’s environment is the prudent move. Interest rates are historically low and there are inflation risks that could lead to higher rates in the future. Thus, locking in now could be very smart. A fixed rate loan also aids in planning in that you “know” what your debt payments will be during the fixed rate period.
- There is, though, an argument to consider a floating rate. While interest rates seem low (and are from a historical perspective), they could certainly go lower. Many studies show that aging demographics and a heavy debt burden tend to have deflationary effects on countries – and the U.S. certainly faces those pressures. If rates do go lower, a floating rate loan would be advantageous. In fact, if you look around the world, rates in the U.S. are among the highest among developed nations. The 1.27% rate on a 10-Year UST compares to other countries’ rates as follows:
- The U.K.’s 10-year government rate is 0.63%
- Spain’s 10-year government rate is 0.35%
- Japan’s 10-year government rate is 0.04%
- Germany’s 10-year government rate is (0.27%) – that’s right…negative 0.27%, meaning that you pay Germany to hold your money. A crazy concept!
There is no “right” answer to this question and in many cases we’ve recommended that clients consider doing some of both. For example, a client with $1 million in debt might consider fixing the rate on $500k and letting the other $500k float. To an extent, by splitting the structure, you’re a winner either way that rates go without having to be “right” about the future.
One final word of caution, no matter whether you decide to fix or float your interest rate: understand your loan structure. Particularly if you are considering a fixed rate for all/part of your debt structure you need to understand how that rate is being fixed. Traditional fixed rates are very straight forward – the bank simply offers a fixed rate. In recent years, though, many banks offer “fixed” rates via more complex loan structures (often via what’s known as an “Interest Rate Swap”). “Swaps” aren’t bad, per se, but they often introduce the potential for pre-payment penalties for borrowers, especially if rates go down (which could make it costly to refinance in the future). We are always happy to talk to you about the structure of your loans and would welcome your call at any time.