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At the risk of dating myself, I started my banking career when the Prime Rate was 20.50 percent. That was down from a record high of 21.50 percent in December 1980. My first mortgage loan was 16.50 percent, which seemed attractive compared to a high of around 18.50 percent.
Fast-forward to the past 10 years, which have experienced exceptionally low interest rates for an extended period due to the severe recession beginning in 2008 and a secular decline in long term rates that was further supported by the Federal Reserve Bank’s Quantitative Easing Program. The Prime Rate was held at a low of 3.25 percent for seven years from the end of 2008 in an effort to stimulate economic activity.
The Fed is now increasing the Federal Funds Rate, which drives the Prime Rate, increasing it 150 basis points (1.50 percent) from its low. Based upon the current Fed Funds futures market, the Prime Rate is expected to exceed 6 percent by the end of 2019 from its current level of 4.75 percent. The 10-year Treasury Note, which influences long-term borrowing rates, has also moved higher—from 2.47 percent in December 2017 to more than 3.06 percent as of this writing. The forward markets forecast additional increases for this benchmark in the future.
Many business people, as well as many bankers, have never operated in a rising interest rate environment. As the Fed restores the normality of fluctuating interest rates, and with interest rates generally rising, what’s a business person to do?
Many of the answers to this question depend on the size of your business, the amount you are borrowing, and the current structure of your loans. Some things to consider:
Most lines of credit are structured on a floating rate basis and the rates on those loans will certainly increase with changes in the Prime Rate. Banks will not, in most instances, be willing to fix a rate on a line of credit. If you’re borrowing $1 million, a 1 percent change to interest rates equates to $10,000 annually. Think about the impact on your profitability that rising interest rates might have. Larger companies may have the option of purchasing a SWAP instrument that effectively fixes the interest rate on floating-rate debt.
If you currently have long-term fixed rates on real estate or fully amortizing equipment loans, you can rest easy that your rate will not be affected by these increases. However, often times term financing is adjustable, meaning the rate is fixed for a shorter period of time than the term of the loan and adjusts periodically. For those with rates subject to change over the next 18-24 months, either through adjustment or balloon maturity, you might seek to reset rates with your lender now and extend for a longer term before rates go up in the future. Understanding any prepayment terms of your fixed-rate loans is an important consideration.
For businesses with loan agreements containing debt-service coverage requirements and/or fixed-charge cover-age ratios, rising interest rates could possibly result in covenant defaults as interest expense increases. Modeling the impact of rising interest rates on these ratios will help you understand your margin of error and avoid potential conflict with your lender. Covenant defaults could also result in your interest rates being reset generally, including existing fixed-rate loans.
While further out in its impact, borrowers with financing tied to LIBOR (the London Interbank Offered Rate) should be aware that the LIBOR Index will be phased out in 2021 and replaced with a to-be-finalized index that will be developed between now and then. This is the result of manipulations by certain market participants during the financial crisis that impugned the integrity and reliability of LIBOR for market pricing. As of now, it appears that the Secured Overnight Financing Rate (SOFR) will be the replacement, but it is still in development; it is difficult to predict whether SOFR will trade higher or lower than LIBOR and to understand its impact on borrowing costs generally.
While a rising interest rate environment may change the calculus around business investment decisions, interest rates still remain low by historical standards, and owners should not be dissuaded from making those investments where the projected profits exceed the cost of this capital. The impact of higher financing costs will be unique to each business and can be evaluated thoroughly with the help of your fin-ancial advisers, particularly with your banker.
Mark Larrabee is the Kansas City president and CEO for Arvest Bank.
P | 913.279.3370
E | mlarrabee@arvest.com