As a business owner, when you obtain a loan should you take a fixed or a floating interest rate? This question has come up a lot lately when speaking with business owners. So I’ll tell you the same thing I tell them when they ask that question – “It depends.” (Don’t you love that answer?)
Currently, we are in a rising rate environment, and most of the people who ask me this question initially prefer the idea of a fixed interest rate. Their thinking is that, because rates are uncertain, they would like the security and stability of a fixed rate – they always know what their monthly payment will be. And while this is true to a point, the answer to the “Fixed vs. Floating” question is not always that simple. Let’s take a look at the basics of commercial lending rates.
In the world of commercial/business loans, loans for things like equipment, startup, working capital, etc. are typically fixed-rate loans, but floating rates are preferred by some businesses. Floating rates, on the other hand, are often tied to a certain index – the US Prime Rate prime rate is the most common and is published in the Wall Street Journal daily. As a rule of thumb, the US Prime Rate is typically 3 points higher than the federal fund’s rate set by the Federal Reserve. While most banks stay closely tied to the US Prime Rate, banks can set their prime rate at whatever they want.
A floating rate will also have a margin for the lender built in. In other words, if you obtain a loan today set at “prime plus 1%” then your total interest rate would be prime (currently 4.25%) plus 1% for a floating rate of 5.25%. If the US Prime Rate changes, then your rate changes. But the margin, in almost all cases, won’t change.
How does the bank go about setting interest rates?
A bank sets their interest rates based on two kinds of risk – credit risk and interest rate risk. Credit risk is how risky the bank views your loan – the lower the risk, the lower your rate. Interest rate risk is the likelihood of rate changes that would impact bank profitability. So, for fixed interest rates – if the bank gives you a 4% fixed rate, and then interest rates go up so much they have to pay 4.00% interest on their savings accounts, the bank is not making any money. For floating rates, if rates go up, your rate goes up. So the risk to the bank is less, and they can offer initial rates that are lower than fixed rates.
You can look at it this way – security costs more. If you want the security of always knowing what your payment will be, your fixed rate will cost a little more than a floating rate. Floating rates give you less security (and conversely, more security for the bank), so you will pay a lower interest rate, to begin with.
So which interest rate is right for you?
It depends. If you prefer more security, a fixed rate might be right for you. If you’re looking for a lower starting rate, and are willing to take a chance that rates might go up, look into a floating rate. Something that you may not have thought of to consider with floating rates is this – if rates increase, this often means the economy is performing better, so theoretically, your business should be performing better as well. Thus making it easier for you to absorb a rise in your monthly payment.
The same basic philosophy applies to real estate – as interest rates increase, owning a building becomes more expensive, so business owners are more willing to pay more for rent. If you’re a landlord, this means you can raise the rent to compensate for any increase in interest payments you have to make as your floating rate increases. Conversely, if the economy performs worse, interest rates will go down and you will likely have to drop the amount you charge for rent.
That’s a good basic overview of Fixed vs. Floating interest rates. There are many other factors that you would need to consider taking a loan and I would definitely advise you to have a discussion with your tax professional as well.
But if your tax person is really boring, then stop by and see me instead – we can go into greater detail and discuss which type of loan would be best for your business. (And then you can run it by your tax person later.)