Floating or fixed?

You need a business loan, but with
today’s volatile market, what type
of loan is the best for your company? A fixed rate at today’s interest rate or
a floating rate that could change in the

Today, many business owners are opting for an interest rate hedge on their
loans, which allows the bank to offer the
best of both worlds.

“All customers seeking a new term loan
or line of credit should strongly consider
the benefits of an interest rate hedge for
their business before finalizing their
funding needs,” says Devon Jenkins, vice
president and relationship manager of
Wells Fargo Business Banking. “This
applies to real estate investors, manufacturers or service companies. An interest
rate hedge satisfies a company’s need for
short- or long-term fixed-rate financing.”

Smart Business talked to Jenkins
about how interest rate hedging is helping business owners of all sizes.

What kind of benefit does interest rate
hedging offer over fixed-rate loans?

Interest rate hedging products offer customers flexibility, portability, and typically
an opportunity to minimize loan prepayment fees. An interest rate swap for example effectively turns a floating rate loan
with variable payments into a fixed rate
with fixed payments. The swap is separate from the loan and may be transferable to other debt. Since the basic loan
structure is not changed, customers will
typically not incur a prepayment fee on a
floating rate loan, should they decide to
pay the loan off early. A swap can allow
you to fix the rate on your loan for a period less than the actual loan and for a portion of the loan principal. For example,
the client may only want a fixed rate for
three years of a 5-year loan, or hedge just
$1 million of a $2 million loan. This type of
flexibility is available with many interest
rate hedging products.

How long are interest rate hedges effective?

In most cases, we match the swap to the maturity of the loan, so the customer
pays a fixed rate without the worries of
the interest rate environment. As a result
of the fixed rate, the customer knows
exactly what the payment is going to be
even though the interest rates in the market continue to go up and down.

For example, take a five-year balloon
note based on a 15- or 20-year amortization schedule. In a normal fixed-rate scenario such as that, that fixed rate is only
going to be good for five years. With an
interest rate hedge, it is possible to lock
in a rate for a duration that is different
and perhaps even longer than the loan.
So, the hedge allows a customer to manage the risk of interest rate changes separate from the loan.

What types of financial vehicles are eligible
for interest rate hedging?

There are many things that can be
hedged on the public market. We do
interest rate hedges on lines of credit and
term loans. We offer commodity hedges
as well as various solutions that benefit
and help customers manage their market
risk. We’ve done deals as small as
$250,000 and as large as many millions of

How do you know if an interest rate hedge is
right for the customer?

That is determined on a case-by-case
basis as there are a number of factors that
come into play. I’m looking at my customers’ level of sophistication and at their
comfort level with the idea of interest rate
hedging. Do they understand what we are
doing and why we are doing it?

People ask why an interest rate hedge
and the answer is simple. It provides a
win-win situation — both the customer
and the bank benefit from a level of flexibility neither one would have otherwise.

What about repayment or termination?

We can actually build a repayment
schedule based on the hedge. For example, if the customer wants to do additional principal payments because his or her
business may be at a certain point three
years from when the loan is signed, those
extra payments can be built right into the
schedule. Additionally, the customer may
be able to achieve a financial gain from
the early termination of the swap if the
swap rate is below the current market
rates at the time of termination.
Likewise, if the swap rate is above the
current market rates at termination, the
customer may incur a fee.

Is interest rate hedging more or less risky than
traditional fixed rate?

Interest rate hedging offers benefits to
borrowers beyond conventional funding
options. It also gives clients the opportunity to take advantage of a changing interest rate environment. If a client wants a
fixed rate on their loan to achieve certainty in their loan payments, than an interest
rate swap could well be less risky for the

DEVON JENKINS is vice president and relationship manager of
Wells Fargo Business Banking. Reach him at (281) 357-4538 or
[email protected].