Floating or fixed? Featured

8:00pm EDT June 25, 2007

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 future?

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 dollars.

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 client.

DEVON JENKINS is vice president and relationship manager of Wells Fargo Business Banking. Reach him at (281) 357-4538 or Devon.L.Jenkins@wellsfargo.com.