fixed vs. variable rate

July 20, 2022

by a searcher from Pennsylvania State University in Philadelphia, PA, USA

Does anyone have thoughts on pursuing a fixed vs. variable interest rate as part of their financing package? Fixed rates are appealing because there is no uncertainty in an odd market, whereas variable rates are appealing because rates should come back down over the long run (despite a near term hike).

Thanks!

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Reply by a searcher
in Denver, CO, USA

Comparing fixed vs. floating is more complex than just taking a view on where benchmark rates are headed. Each company funds their mix of debt differently based on their: risk tolerance for potentially higher interest, capex funding needs, FCF stability (i.e. ability to absorb higher interest expense), ability to hedge, existing debt maturity profile, ability to refinance the debt in the future, ability to pass through price increases to customers amid a rising rate environment, supplier/customer contract structure (e.g. if price escalators in place), and many many other factors including their best guess of where rates are headed.

For simplicity sake, if you're purely solving for the lowest interest expense, be sure to model each option over the life of the loan using an XIRR formula. As ^redacted‌ mentioned, it's prudent to utilize the forward interest curve in lieu of the existing spot base rate in order to determine a proxy for what expected LIBOR/SOFR will be in the outer years of the loan. If you have access to hedging options, you can also incorporate the hedging costs associated with each option (swapping from fixed to floating or from floating to fixed) to determine if either swap provides better value over the life of the loan.

A note on basing your decision on where you think rates are headed: Forward rates are a highly efficient market where all public macroeconomic information is baked into the forward LIBOR/SOFR curve. This curve is determined via large liquid trades (think multi bn) 24 hours a day in the swaps market across the curve, with all market participants able to view the aggregate trade data in real time. Taking a directional view beyond what every market participant is currently pricing in is more difficult than taking a view on mega cap equities like Apple or Amazon, in my opinion.

This explanation is likely much more in depth than what is required for a small cap loan, but the TLDR is that the rule of thumb is 50%/50% split between fixed and variable funding for any business where both options are available and the interest expense of each option is roughly the same. Feel free to reach out if you'd prefer to discuss live.

Reply by a lender
from University of Missouri in St. Louis, MO, USA

The type of loan you are doing could also have an impact on this discussion. If this was for a real estate loan, equipment loan or something else that is collateral backed, you could refinance it if rates drop. The issue on SBA loans is they are difficult to adjust post close. This is especially relevant if the loan is sold on the secondary market and the bank scraped a big fee. I did a lot of fixed rate loans in the 7's for SBA borrowers in 2019 since we thought rates were going up. Then in 2020 Prime plummeted and they would have been in the 5's if they floated. So there isn't a right answer unless you know where rates are going. However, cost certainty of fixed rates is something you can at least plan around.

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