What to consider when choosing a variable- or fixed-rate loan
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With interest rates rising, our team is getting a lot of questions from customers about whether to choose a fixed- or variable-rate loan. Economic pundits expect the Federal Reserve will continue to raise rates throughout the year in response to continued inflation. Here are some key considerations for anyone looking to finance a loan.
According to Fed Chairman Jerome Powell, the Federal Reserve needs to move quickly to raise interest rates to help reduce rising inflation rates. The annual inflation rate for the United States is now 8.5% for the 12 months ending March 2022, which is the highest since December 1981, according to U.S. Labor Department data. When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy in an attempt to bring inflation down.
In addition to inflation, unemployment rates and the GDP are influencing the Fed’s decision to tighten monetary policy. Together, these factors drive the treasury yield curve, which indicates public sentiment about the health and direction of the economy. For the first time since 2006, the curve is inverted as shifts in the job market increase fears of a recession. The Conference Board projected the U.S. Real GDP will grow less than 3% through 2022 considering Russia’s invasion of Ukraine. What do these factors mean for business owners focused on growth? Here is the good news.
Mergers and acquisitions continue. Leveraging debt to capitalize on a business transaction can be a successful strategic approach, especially if you can lock-in rates before predicted rate increases. In previous years of economic disruption when inflation and interest rates were high, business leaders who made prudent growth decisions were, over time, typically rewarded.
As we head into similar circumstances, business owners should consider the long-term benefits of their growth strategy. These benefits typically outweigh the cost of capital. The rate increases have an impact on cash flow, but when we’ve done sensitivity analyses on interest rates and loan performance, the increases don’t appear to have a dramatic impact overall.
Furthermore, even if rates go up 2%, debt is still less expensive than the cost of equity, which is typically 25% to 40%. If you have plans to grow using debt, now is the time to take advantage of the rates before they increase further.
Loan Choices
Some business owners are reevaluating their growth strategies as the cost of capital increases, including asking which option is best given the current economic situation: fixed- or variable- rate loans.
Frequently, variable-rate loans are structured with lower rates. In addition, lenders are typically willing to extend larger amounts through a variable-rate loan because it reduces the interest rate risk the lender assumes.
In the immediate term, variable-rate loans come with a lower rate, but if the federal funds rate increases, as predicted, so will the interest rate of the loan. Therefore, with the projected interest rate increases, some business owners may be more comfortable with a fixed-rate loan to lock in the interest rates of today for tomorrow. However, should the federal funds rate increases succeed in slowing inflation and interest rates return to current levels, the effects of a short-term rate increase will have a negligible impact over the life of a long-term variable-rate loan.
For some business owners, the biggest advantage of choosing fixed-rate lending is predictability. You can borrow with the confidence knowing your rate and monthly payments will remain unchanged for a fixed period of time, regardless of federal funds rate changes.
Long-term, fixed-rate loans are a boon for business owners contemplating a significant expansion, such as the acquisition of another business, or any major capital investment. If that expansion or investment leads to continuing revenue growth while the interest rate and monthly payments remain stable, the loan becomes that much more affordable each month.
Looking ahead
In the long run, the value of a business is more important than loan type. When choosing the loan type for your company, think about why you are borrowing, the company’s financial condition, your own risk tolerance, and predictions about how the interest rate environment might change in five to ten years. Be sure to consult with key advisors including your own lender and CPA firm to understand both the risks and rewards.
Rick Dennen is the founder, president & CEO of Indianapolis-based Oak Street Funding, a First Financial Bank company with customized loan products and services for specialty lines of business including certified public accountants, registered investment advisors and insurance agents nationwide.