On the heels of the financial crisis, banks tightened their lending policies and many companies couldn’t qualify for inexpensive fixed-rate loans. Instead, they took on variable-rate loans. Interest payments that fluctuate based on the U.S. prime rate or London InterBank Offering Rate (LIBOR) index are a viable option, as long as rates continue to hover near historic lows. But if market indices rise, borrowers with substantial variable-rate loans could be in for a rude awakening.
Putting ‘Low’ Into Perspective
Just how low are today’s rates compared to historic levels? To put current interest rates into perspective, consider the U.S. prime rate, which is the basis for many companies’ variable-rate loans. It’s been set at 3.25 percent since 2008 — its lowest level since the mid-1950s.
By comparison, its 50-year high was 21.5 percent in 1980. The median prime rate from 1947 to present is 8.75 percent. And the most common prime rate (or mode) is 7.5 percent over the same period. If the prime rate jumps to 7.5 percent over the next few years, many companies will be unprepared to absorb the incremental interest expense.
How Long Can Low Rates Last?
A key determinant of prime and other variable-rate indices is the federal funds rate, which is the rate banks charge each other for overnight loans. In January, the Federal Open Market Committee (FOMC) voted to keep the federal funds rate near zero percent until unemployment falls below 6.5 percent. That unemployment level isn’t expected to occur until 2015.
Don’t let low rates lull you into complacency, however. Long-term commercial loan rates are influenced by more than the federal funds rate. And a spike in inflation or a faster-than-expected economic rebound could cause the Fed to tighten its monetary policy sooner rather than later. So, borrowers may need to have a backup plan in case interest rates start to climb.
Do You Need a Back-Up Plan?
If the following conditions apply, you might benefit from converting some of your variable-rate debt into fixed-rate debt:
Your balance sheet includes long-term debt;
Interest on your loans fluctuates according to changes in an index rate, such as LIBOR or the prime rate;
Interest expense is a significant line item on your income statement; and
You lack sufficient assets and cash flow to repay variable loans over the next 12 to 24 months.
Refinancing with a conventional fixed-rate loan is the most obvious way to lock in your rates. But what if you only want to lock in a portion of your variable-rate debt or prefer a different amortization period? In that case, a simpler, more flexible option might be an interest rate swap.
How Swaps Work
Swaps are derivative contracts that operate similar to insurance policies against rising interest rates. Essentially, a borrower can hedge its bets by placing a swap contract on top of a variable rate loan, effectively locking in a fixed rate. If index rates increase more than the bank expects them to, the swap agreement generally pays off for the borrower.
As an added bonus, the Financial Accounting Standards Board (FASB) recently made it easier for non public companies to report simple interest rate swaps. Now small and mid-sized businesses can opt to use settlement value rather than fair value when updating the value of the swap each period, under Accounting Standards Update 2014-13, Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps — Simplified Accounting Approach.
This update reduces compliance costs and income statement volatility, especially for companies with large swaps subject to lengthy durations. Private firms — except for not-for-profits, financial institutions and employee benefit plans — can elect to apply the simplified hedge accounting method on a swap-by-swap basis to new or existing swaps that qualify.
Finding the Variable Interest Rate Optimal Strategy
Today’s Variable Interest Rate is low by historic standards, but they won’t last forever. Many borrowers may find it prudent to convert variable-rate payments into fixed-rate payments, using traditional fixed-rate loans, swaps or a combination of the two. Many variables factor into the decision, including your company’s sensitivity to interest rate volatility, the cost of swaps and expected future cash flows. A financial professional can help you develop an effective strategy to minimize your long-term debt costs.
Ready to Make a Deal?
Many Baby Boomers are planning to sell their businesses over the next few years. If you’re contemplating a sale, rising interest rates could affect the price you’ll fetch in the marketplace. As long as debt is cheap, buyers can afford to pay higher prices. But if the cost of debt suddenly increases, it could reduce your probable selling price — all else being equal.
While interest rates are at historic lows, it might be a good time to put your business on the market. Conversely, it also could be a good time to shop around for businesses to invest in. If you’re looking to expand, you might be able to afford to buy more while rates are low.
However, the cost of debt is just one factor that affects a business’s value. Consult with your financial adviser to determine how rates might affect a firm’s market value and the optimal time to buy or sell.