Fixed vs. Floating Rates: Can Your Loan Rate Help Business Growth?
Any franchise operator looking for credit needs to make sure he is getting the right deal, not just the "best" deal.
By Brian Frank
Franchisees seeking financing need to weigh several questions: Is now the right time to apply for credit? How will I use a loan? Which bank or lender should I use? These are all key factors to help a business owner decide when, where and how to pursue financing, but one of the most important aspects of any business financing decision is whether to apply for a fixed or floating rate loan.
With interest rates at historic lows for nearly a decade, the fixed or floating (also known as adjustable) rate loan factor recently hasn't been as critical in the financing decision process as it will become over the next few years. There is much buzz about the schedule the Federal Reserve will take for interest rate increases following December's first hike, but this shouldn't cause panic in a borrower. Rates are still very favorable for borrowers even with the initial 25 basis point increase and subsequent financial institution loan adjustments, and steep, steady increases that would bring interest rates back to their most recent peak in 2007-2008 aren't likely in the near future.
Since fear of skyrocketing interest rates shouldn't hinder borrowers, how do franchise operators accurately evaluate whether fixed or adjustable rate debt makes more sense for their business? When considering a loan or line of credit, evaluate the following factors:
Your time horizon.
One of the most important aspects when seeking a fixed-rate or floating-rate loan is your business' timeline and how you will use the credit, as that determines the term length and type of loan to pursue. Do you need to purchase new equipment or a fleet vehicle (short-term loan), or are you investing in a commercial mortgage, store remodel, new store construction or an acquisition of existing stores (long-term loan)?
Short-term loans, with terms of seven years or less, can be cheaper now with a floating rate because the all-in cost (equal to the LIBOR interest rate index plus a bank's rate spread) on an adjustable loan is generally lower than the cost of a fixed-rate product. This will likely remain true over the next few years, and interest rates would have to significantly increase over multiple quarters to cause a major impact to the affordability of floating rate loans.
Annual percentage rates on fixed-rate loans, meanwhile, currently can be nearly double that for a floating rate product, meaning the total cost of interest over the time of a short-term, floating-rate loan could be much cheaper than a fixed-rate product. A fixed-rate loan, on the other hand, makes sense for longer term debt that would come due in 10 years or more, when rates will have fully adjusted. Fixed rates are still essentially as low as they can be, so companies considering a fixed-rate product should lock in financing as soon as possible to avoid paying a higher proportion of interest during monthly payments over the life of the loan.
Your company's history.
More established franchise operators with cash on hand may want to finance a purchase – perhaps for tax, cash flow or budget reasons – but aim to pay it off before the term is over. If this is the goal, consider an adjustable-rate product, which generally gives a borrower more flexibility to either pay down the loan at an accelerated rate or simply make the monthly payments per the lending agreement.
Floating-rate products can be a better option for growing businesses because fixed-rate loans often carry more stringent pre-payment penalties. This means a business owner who pays off a loan before the term could spend more in fees and expenses versus investing the cash saved in the growth of your business.
Paying off a loan in a condensed timeframe also can boost your company's bottom line in the near future. By wiping a debt off the books, franchise owners can free up resources that were going toward paying the loan note to reinvest in their business and employees, encouraging more growth. Operators who pre-pay a loan also could potentially look to buy an additional franchise with the new cash on hand and recent credit history as a good borrower. If a cash infusion isn't needed right away, consider placing the additional funds in a short-term investment vehicle or staying liquid until interest rates climb higher and deposit and investment products yield a higher return.
Your comfort level.
As an owner of a business, your time and attention are focused on running the day-to-day operations of your company, including providing customers with excellent service, managing inventory and reconciling sales to your bank account. The last thing you want is to be worrying about what interest rates are doing quarter-to-quarter and how that might affect a loan payment schedule (and, in turn, company budget). Locking in a fixed rate on a loan provides predictability in payment amounts and allows for better monthly budget forecasting. Larger franchise operators that have a financial executive may be more likely to consider an adjustable rate loan, because they have an eye to financial statements and can make a decision on when to pay down debt or to refinance into a fixed-rate product.
Any franchise operator looking for credit needs to make sure he is getting the right deal, not just the "best" deal. Before submitting an application, talk to your banker or financial advisor to get clear explanations of the products and how a fixed or floating rate loan could benefit your operation. Taking out a loan isn't just about what your operation is now – it's tied to who you want to be in the future and how the right financial moves can get your business there faster.
Brian Frank is head of restaurant and franchise finance for TD Bank. Find him at fransocial.franchise.org.