Contributed by Rob Perez on behalf of First Federal Bank
Rising interest rates have dominated daily headlines and sounded the alarm for borrowers. For businesses, the most common interest rate index, Prime rate, is now at 7.00% and likely rising further. Though interest rates are certainly higher than in recent times, they pale in comparison to the peak 21.5% Prime rate in December of 1980. While no one anticipates interest levels close to 1980, it doesn’t make today’s rising rates any more palatable. Regardless of whether it’s 1980 or 2022, there can still be good business reasons to borrow while minimizing your borrowing costs.
Reasons to consider borrowing despite higher rates:
- First, your business generates a return on equity higher than your borrowing rate. For example, if your return on equity (Profit/Equity) is 10% and your cost of borrowing is 7%.
- Additionally, borrowing can help you retain your liquidity, which is crucial to managing unexpected changes to your business and maintaining flexibility.
- Finally, loan proceeds can enhance your business by providing needed working capital, purchasing assets that improve efficiencies/profit margins, etc. Even real estate acquisition can make sense when ownership benefits like mitigating rent escalations are considered.
Just don’t get caught up in the headlines. Instead, stay focused on the fundamental benefits of borrowing.
Once you decide that borrowing makes business sense, then focus on:
- Borrowing at the lowest rate
- Borrowing at terms that don’t stress your business
Remember, obtaining a loan is about more than interest rates.
- Understanding the overall cost of borrowing is important. For example, let’s say you need a 5-year, $100,000 loan, which you can obtain at 7%, a 1% loan fee and a $500 documentation fee. In this example, your total cost of borrowing (including the fees), applied to your rate (known as APR or annual percentage rate), is 7.37%. In this case, it would be more advantageous to negotiate a 7.25% loan with no ancillary costs, assuming the other loan terms are comparable.
- Look closely at your borrowing terms (loan covenants). For example, can you pay off all or a portion of the loan without penalty for longer-term loans? Are the financial covenants set at levels your business can achieve with some margin for error? Can you cap the level of future rate increases?
- When borrowing for a longer term, consider shorter fixed rate periods or even floating rate indices like Prime, that are lower than the longer fixed rate option periods. This strategy could make sense if you feel rising rates are peaking and may go down before your rate reset date or loan maturity. There are risks to this strategy, and it should only be considered if you have sufficient liquidity to pay off the loan without negatively impacting working capital or have ample cash flow to cover payment increases.
- Talk to your bank to get a sense of their interest in addressing your needs, as well as their various financing requirements. If their reaction is less than enthusiastic, consider talking to other banks.
If you’re considering borrowing for your business, give our business lending team a call. With convenient locations in both Magic and Treasure Valleys, we’re here to help. Visit bankfirstfed.com/business to learn more.