If you have outstanding debt on a loan, you may be considering taking advantage of floating interest rates, which are at an all-time low.
While the potential reward is tempting, there is plenty of risk as well, according to Sean Richardson, the NorthCoast president and CEO of FirstMerit Bank.
“The concern is how long those low floating rates will last,” says Richardson. “When they go up, there is the potential for them to go up a lot.”
However, if you simply fix the interest rate on your debt, you may be paying much more in exchange for the peace of mind of a fixed rate.
Fortunately, you have more choices than just a floating or fixed rate.
Smart Business spoke to Richardson about how to have the best of both worlds when managing interest rate risk.
What are the dangers of interest rate risk in a rising rate environment?
The danger is getting caught when rates go up. If you have debt outstanding with a floating rate and you don’t do anything to fix those rates, you are at risk. When rates go up, you will be paying higher interest costs, which may affect all aspects of your business.
The potential for rates to drastically change is very real. We are now at all-time lows, and if you look back to when rates where close to these levels, you’ll find that they moved a lot in a short period of time.
For example, in 2004, floating rates increased 4 percent in a two-year period. People have a short memory and are surprised by how fast rates can move and how much they can move. The worry is, if you have a certain rate today, can you handle a rise that significant in so short a time? Most people would say no.
What can businesses do to protect themselves from rising rate risk?
The No. 1 solution is an interest rate swap. A swap is a product banks offer clients that allows them to fix rates on all or a portion of their debt.
Traditional fixed-rate loans have no flexibility from an interest rate risk management perspective. The rate is fixed for the entire loan balance. With swaps you have a lot of flexibility; you don’t have to fix the rate of all of the debt. With a swap you can really manage your interest rate risk.
How do interest rate swaps work?
Assume you have a $10 million floating rate term loan; you can manage it by putting a fixed rate on $5 million of it for five years, $3 million for four years, and leave the other part floating, providing you are comfortable having some floating rate debt. You can modify the interest rate characteristics of portions of your debt as well as the duration of those rates.
Managing interest rate risk is the big benefit of an interest rate swap. In today’s interest rate environment it may not make sense to have all of your debt fixed as you are not getting the benefit of the low floating ratings available today.
In the situation above, if rates go up you have protected yourself from rate increases by fixing a portion of the debt. If they don’t go up, at least you’ve protected yourself by taking advantage of the low floating rates.
Risk management helps people sleep better at night. Rather than force you at the outset to choose either a fixed or floating rate for the life of the loan, swaps allow you to take advantage of the historically low floating rates while protecting yourself in the event of a significant floating rate increase.
How can I decide how much risk is right for me?
People ask me all the time what they should do. ‘Should I fix all this? Float some of it?’ I tell them it’s not up to me; it’s up to you.
It depends on the company. If you want the debt but have enough cash on hand to pay it off, you can take a little more risk and float your rate.
On the other hand, if your company doesn’t have a lot of cash and can’t handle an interest rate increase, you might consider fixing all of your debt.
Then there are the companies in between. Each company’s needs are based on its specific risk tolerance and company profile.
There are also many other factors that may enter into the decision. The company’s debt may be from a piece of real estate. Is the company planning to sell it? Does it want the flexibility to pay it off early?
We can guide them and help them, but we need to learn about them to help them make an educated decision.
When doing an interest rate swap, what common pitfalls should companies avoid?
One caution for clients: Companies usually want to fix their rates when rates start to move. The problem there is your fixed rate at the time the loan was originated may be a lot higher at that time than in today’s rate environment.
For example, say we quoted a fixed rate today at 6 percent but you took a lower floating rate. However, in six months you get nervous about floating rates rising and you decide you want to fix your rate. By then I may be quoting you 7 or 7-and-a- half percent for a fixed rate. It is a process that requires some careful consideration. Your banker can help you make the best decision.
Rate swaps are not be-all and end-all solutions, but with today’s low rates, it’s a tool companies should consider using as a way to manage the risk of a potential rapid rise in their future interest expense.
Sean Richardson is the NorthCoast president and CEO of FirstMerit Bank. Reach him at Sean.Richardson@firstmerit.com or (216) 802-6565.