Today’s fluctuating interest rate environment is leading many business owners to consider longer term fixed rates. One way to obtain a long term fixed rate is via an interest rate swap. In simple terms, an interest rate swap is the following:
- The bank makes a variable rate loan to the borrower. It is typically preferred by banks to make variable rate loans to have a locked-in margin.
- The borrower signs some additional documents so they “swap” the variable rate loan for a long-term fixed rate (up to 25 years).
- The bank gets to continue to fund its balance sheet in the preferred way with variable rate money and the borrower gets the long-term fixed rate they are seeking to eliminate interest rate risk for a long period of time.
With the current flat yield curve, the interest rate differential between fixed rates and variable rates is less than typical. With the 12/31/18 ten-year Treasury at 2.76% and the 30 day LIBOR at 2.35%, there is only a 41 basis point spread between these variable rate and fixed rate indexes. This spread has shrunk from 90 basis points as recently as 11/12/18. Looking back since 2015 when Prime was at 3.25%, Prime has increased 2.25% to the current 5.50%, with discussions of further increases in 2019. During this same time period, the ten year US Treasury has increased less than 1.00%.
One benefit of fixing, at least a portion of your loans long-term, is the elimination of the risks associated with a rising interest rate market. With a fixed rate loan, a business can accurately project interest payments and the underlying cost of the loan. We are starting to see loans mature that had rates in the 3.00 to 4.50% range and are now repricing into the 5.50% to 6.50% range based on the Fed increasing interest rates. A long-term fixed rate takes this financing risk off of the table for you.
What are the Risks of Swapping to a Fixed Rate?
An interest rate swap is a contracted hedge, so it isn’t for everyone. One considering an interest rate swap needs to meet some criteria like an “accredited investor” needs to for certain types of investments. Given this type of financing is an actual trade, the prepayment penalty is non-negotiable as it is set by the market. Here is a simple way to understand how it works:
- Say you enter into a 10-year fixed rate swap today and the interest rate is 6%. Three years from now someone offers you too much money for the property or the company being financed. Between now and then rates for the equivalent remaining term have risen to 7%. You now have an interest rate contract that is below the then present market interest rate and will receive a prepayment premium (money to the Borrower) to terminate that contract.
- The reverse is also true. Under the same scenario as listed above, someone offers you too much money for your property/company. However, say we have entered a recession and interest rates for the remaining term are now at 5%. You then have an interest rate contract of 6% that is higher than the then current market rate and you have to pay to terminate the contract – a prepayment penalty to the borrower.
- To be clear, the prepayment is non-negotiable. However, it is the only pre-pay scenario where the borrower actually can get paid.
- There are some scenarios where collateral can be substituted and/or the swap can be assumed by a different borrower. However, these are subject to credit approval and various other factors.
A Strategic Approach
The borrowing strategy you to follow for your business should be thoughtfully constructed to consider how much debt you have, how long it is realistically going to be in place, what flexibility you need, the direction of interest rates. It can make sense to take your total debt and divide into several different durations to smooth out some of your interest rate risk and still allow for pre-payment flexibility.
There’s no “best practice” when it comes to selecting a fixed or variable rate; structuring your loans properly is a combination of art, science, and well-informed judgment. Trying to time the movement of interest rates perfectly is not realistic. Smart business leaders work with an experienced business banker who can present options to match your tolerance for interest rate risk and structure your debt to meet your specific needs and tolerances.
About the Authors
Tom Detienne is Market President – Southeast Region, at Investors Community Bank. He has been with the bank since 2001 and has more than 25 years of relevant banking experience. Tom is focused on closely held business and commercial real estate borrowers.
Will Deppiesse has been serving customers’ banking needs for nearly 20 years and is Vice President—Business Banking at Investors Community Bank. He enjoys the small bank setting where he can creatively help small businesses access the capital they need to grow. Will specializes in manufacturing, commercial real estate, SBA lending, trucking, dentists, contractors, making connections, advising and business strategy.