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Posted on OCT 16, 2014

Fixed vs. Variable-rate Debt: What’s Your Business Strategy?

Just like the classic fable The Boy Who Cried Wolf, you may have been tuning out the Federal Reserve's warnings over the past couple of years that interest rates will soon rise. But don't be too quick to ignore the message—rate increases are still expected. In September, the Federal Reserve's Federal Open Market Committee indicated that it expects to begin raising interest rates sometime in 2015.

For businesses with borrowing needs, this presents an excellent opportunity to establish, or review, your interest rate strategy. “Business owners, especially those with a fair amount of debt, should have an interest rate strategy,” says Eric Johnson, Senior Vice President, Commercial Banking at Johnson Bank.

Questions to Ask

Questions to discuss with your CFO, finance committee, banker or all of the above, include:

  • How does our business react to a rising interest rate environment?
    Some businesses can pass on the cost of increased interest expense to their customers. Others can't, so rising rates put negative pressure on their margins and reduce profitability.
  • How much interest rate risk are we willing to take?
  • What percentage of our debt should be fixed‐rate vs. variable‐rate?
  • What is the outlook for interest rates—rising, steady or declining?

Johnson continues, “Once you have an established interest rate strategy, it's easier to pursue the proper loan structure and be sure you get the best rate or spread.”

Weigh the Pros and Cons

With fixed‐rate loans, the lender assumes the interest rate risk during the term of the loan. With variable‐rate loans, you assume the risk of rising rates.

Historically, businesses have used variable rates for their short‐term working capital needs and fixed‐rate debt for their long‐term capital needs, such as equipment or real estate financing. “That's the traditional way of thinking,” Johnson notes. Conventional wisdom also says that when rates are expected to rise, you should choose fixed‐rate instruments over variable‐rate ones.

“But it's a good idea to think about debt in nontraditional ways, too,” Johnson says. “For example, over the past four years, businesses that have borrowed with variable‐rate instruments have saved significant amounts of money because they've been willing to assume some interest rate risk themselves.” Banks are generally neutral with respect to whether a borrower chooses a fixed or variable rate option leaving the decision up to the company's management team.

Turn to the Experts

Johnson Bank has experienced advisors who can work with you to determine the best strategy for your company. Contact a Johnson Bank commercial banking advisor today.