Interest rates

Depending who you’re talking to, today’s economy is either down, picking up nicely or very healthy. With so much uncertainty how does anyone know which is the best way to go when considering applying for a loan?

Is a variable rate loan the smart idea? Or should business owners look toward fixed rates?

“Right now business owners should take a look at fixing the interest rate on some of their loans,” says Craig Johnson, president of Franklin Bank. “The 10-year treasury loan rate today is about 4.60 percent and you’ve got the prime rate at 8.25 percent.”

Smart Business talked to Johnson about getting the best possible interest rate on a loan.

What is an inverted yield curve?
Historically, short-term rates are the lowest rates on the curve. As you go up the curve, or further out in time, rates go up. Today you have a prime (short-term) rate at 8.25 percent and the federal discount rate is at 5.25 percent. Meanwhile, the 3-, 5- and 10-year treasuries are essentially the same, around 4.60 each so y short-term rates are significantly higher than long-term rates. The best way to visualize this is to draw a box graph. At the top are interest rates, and the bottom is time. Generally speaking, as time passes, interest rates go up. But what you have today is almost the opposite. Rates are high on the short-term and flatten out and even become inverted in the long-term. That is called an inverted yield curve. What does it mean to business owners? It means there is uncertainty in the market and that long-term outlook is potentially more favorable than short-term interest rates imply.

Is now a good time for business owners to fix the interest rates on their loans?
You really have to look at a couple of factors. First of all, what is the likelihood that the Federal Reserve will lower rates for the next 12 to 18 months? The reserve didn’t raise rates during their last two meetings, and their comments have indicated that they are taking a neutral position relative to future rate increases at this point. Given that, along with indications that economy is strengthening, one might assume that rates will trend downward in the next 12 months. As for whether business owners should fix interest rates on their loans, this is a risk-reward scenario. I advise clients to look at a long-term horizon, fix a portion of the debt and keep a portion of it variable. History will tell you that you’d be better off with a balance. By doing this, you are essentially buying yourself a bit of an insurance policy. Keep in mind that fixed rate loans will carry pre-payment penalties so if you try to refinance them when rates come down it will cost you more.

Does it matter if it’s a business or residential loan?
From a residential standpoint, today there is not a material difference between a variable rate loan and a 30-year fixed loan. For example, a five-year adjustable rate mortgage is around 6 percent today, while a 30-year mortgage is around 6.5 percent. From a homeowner’s perspective, there is not much of a risk-reward for taking the five-year loan over the 30-year loan. From a businessperson’s standpoint, I refer back to the last question and advice clients to balance risk over a period of time with some variable-rate and fixed-rate debt.

Do interest rates effect the housing market?
Certainly they can whoever I don’t think in today’s environment that interest rates are the significant driver in the slowdown in the housing market. If you evaluate long term mortgage interest rates as a whole, they are not materially different than they were 12 to 24 months ago. There are outside factors other than interest rates that effect interest rates in the housing market – for example, uncertainty with the economy and marketplace. In Michigan, we are affected by continued uncertainty with some of the areas major employers. So the housing market slowdown more likely has to do with individual’s uncertainty with their jobs and with the economy in the local market.

So what’s your advice?
I think that from a business owner’s perspective, you need to look at balancing debt with some fixed and variable rate debt. I think from a homeowner’s perspective, there is little risk-reward to a variable rate loan. They can always refinance later if the curve changes and rates change for the better.

Craig Johnson is president of Franklin Bank. He can be reached at (248) 358-6459 or [email protected].