Fixed rate or floating rate? What type of loan should you get for your company?
It’s one of the main questions business owners ask when approaching banks to borrow money. The answer is that it depends.
It’s not just about whether rates are expected to go up or down. You should also consider a host of other factors, such as your risk appetite, growth prospects, the loan’s amortization period and the stability of your revenue.
“It’s not black and white,” says David Ure, Director, Corporate Financing at BDC. “Rates are just one piece of the puzzle. It depends on the business, your view of the market and all kinds of things internally within the company.”
Ure says clients often ask him if it’s better to float or fix, but it’s difficult to give advice because each entrepreneur’s position is unique. “We can give clients information to help guide them, but we can’t tell them what to do. It’s very specific to each situation.”
What is the difference between fixed and variable interest rates?
A fixed interest rate is a rate that doesn’t change over the term of the financing. Financial institutions generally set the rate based on bond yields in the bond markets.
A fixed-rate loan typically can’t be paid back ahead of schedule without the lender’s permission; an early-payment penalty is usually required.
A variable rate (also known as a floating rate) can vary over the loan term. It is based on a reference rate, which in most cases is the prime rate plus several additional percentage points of interest to cover the lender’s risk in lending the money. The prime rate is based on the Bank of Canada’s overnight rate.
For example, if the prime rate is 5%, a lender may charge a customer three additional percentage points above the prime rate to cover the bank’s risk—in other words, 8%.
The Bank of Canada adjusts its overnight rate depending on inflation and other economic factors. When the overnight rate is raised or lowered, the prime rate generally moves with it, with a possible delay of a few days. And that in turn causes rates charged on floating-rate loans to move up or down by the same amount.
In contrast to a fixed-rate loan, a floating-rate loan can generally be repaid with lump-sum principal payments up to a specific amount without penalty.
(At BDC, clients can pay up to 15% without penalty annually on both variable and fixed rate loans.)
Are variable rates lower than fixed rates?
Fixed and floating rates are generally different because they aren’t set in the same way. Fixed rates are almost always higher than floating rates at any given time, although this can vary in more volatile economic environments. This is because of a premium that financial institutions charge on fixed-rate loans to account for their risk in fixing the rate (known as “basis risk”).
The risk lies in the possibility that rates could rise; if that happens, the market value of fixed-rate loans declines, which can greatly increase the risk to the lender.
In comparison, there’s much less risk for a lender when issuing a floating-term loan because the risk is borne by the borrower.
What is the difference between blended and linear payment loans?
A fixed-rate loan can be repaid with either blended payments or linear payments (also known as straight-line amortization).
Blended payments stay the same over the entire term of the financing or amortization period. As the principal is paid off, a steadily increasing portion of each monthly payment goes toward paying down the principal.
Meanwhile, with linear payments, the total amount paid each month goes down over the entire term of the financing or amortization period. You pay back the same amount of principal each month, plus a steadily decreasing interest payment as the principal is repaid.
Less interest is paid over the course of the loan with linear payment than blended payment assuming the same interest rate. This is because with linear payment, more of the payment is applied to the principal during the initial period.
Floating-rate blended payment isn’t generally offered by commercial lenders.
When should you choose a fixed or variable rate?
Businesses should consider several factors when weighing whether to get a fixed-rate or floating-rate loan:
1. Interest rate trends
Where are we in the interest rate cycle? It’s the first question borrowers wonder when considering whether to fix or float. And for good reason. The decision could result in overpaying on your loan for years to come—or saving a bundle.
“It often comes down to your market view,” Ure says. “If you think rates are going to rise, it may be time to fix. If you think we’re at a peak, then I would probably float.”
It's usually fairly clear when interest rates are likely to go up, down or stay flat for a while. Central bankers and economists typically discuss upcoming interest rate trends months in advance. “These things don’t happen in a vacuum,” Ure says. “You usually hear about it well in advance. That’s the time to start thinking about these things. What you don’t want to do is to be caught off guard.”
He recommends keeping an eye on the economy and interest rate environment through sources such as BDC’s Monthly Economic Letter.
2. Amortization period
The amortization period, or length of time to repay the loan, can also affect your decision to fix or float. Generally speaking, the longer your lending horizon, the more it may make sense to float, even if interest rates are rising.
“You're probably better off floating if your lending horizon is far away,” Ure says. “You may pay a little bit more now if rates are higher, but there will be a point at which you're not paying as much as if you had fixed. Over time you’re probably going to be slightly ahead with floating.”
On the other hand, if your amortization period is five years or less, it may make more sense to fix, especially if rates are rising or about to rise.
3. Growth prospects
Business owners who expect revenues or margins to grow are likely less concerned with increasing interest rates and may be more partial to floating-rate loans. That’s because higher sales or profits are likely to offset any increase in
interest rates, and by floating with the market, they may be able to take advantage of lower interest rates over time.
“It doesn’t matter as much if you’re in a significant growth mode,” Ure says. “If rates go up, you’re kind of okay with that, but then you’re going to benefit if rates go down.”
What’s important in this case is to do solid financial planning, including preparing cash flow forecasts. This will allow you to see how any rate increases could impact your working capital and do contingency planning.
4. Revenue stability
A company that expects very constant revenue in coming years may be better off with a fixed-rate loan. This lets the business turn a variable cost into a fixed one, which gives a more stable picture of its finances.
“Fixing lets me know exactly what my margins are going to be and lets me forecast out exactly my profitability,” Ure says.
Companies in this situation include commercial real estate operators that lease to commercial tenants, who pay rent that is fixed for several years. “You’re getting a fixed revenue and you know what your margin is, so it makes sense to fix your interest rate even if the amortization is longer, just because you know the revenue you’re getting in,” he says.
An analogous situation is a loan to buy equipment for a specific project. “If it’s a five-year project and I amortize the financing over five years, then if I know the fixed cost of funds, I have a better idea of my margins for that five-year contract,” Ure says. “You can fix the cost of funds so it’s no longer a variable, and you can better control your margins.”
5. Company size
Your company’s size can be a factor in the fix-versus-float decision. Larger businesses are often more prone to float because floating-rate loans tend to be cheaper in the long run. Bigger companies are also usually better positioned to absorb the risk of potentially higher interest rates.
A smaller company with tighter cash flow may be more inclined to fix their loan rate in order to reduce the risk of an interest rate surprise.
6. Risk appetite
The decision is often heavily influenced by risk tolerance. An entrepreneur with higher risk appetite may not mind floating if this saves money. One who is risk averse may fix if it helps them sleep at night.
Ure gives the example of a business owner whose company was growing quickly but still decided to obtain a fixed-rate loan. “As long as it’s fixed, I don’t have to worry about any surprises,” the entrepreneur told Ure. “He just felt it was one less
thing to worry about. It’s off to the side now, and he can just focus on growing his business and other things which he may not have as much control over.”
Can you switch from variable to fixed rate?
It’s generally possible to switch from a variable- to a fixed-rate loan during the term of the loan (and vice versa), but some caveats apply.
1. Switching from floating to fixed
This can be done with the payment of a minor amendment fee. Note that you can switch to either fixed blended payment or fixed linear payment.
2. Switching from fixed to floating
Switching from fixed to floating is also possible, but the borrower is usually charged a penalty based on the remaining principal and any difference between the floating rate and the fixed rate. This can be a substantial amount if the difference between the two rates is large.
Such a switch may make sense if the floating rate is very close to the fixed rate and you expect interest rates to fall—but only if you don’t have a large outstanding loan balance. “If you’re going to do this, it’s best when you’ve had the loan for a while because your principal is less,” Ure says.
Note that you can only switch from fixed to floating linear payment. Floating-rate blended payment isn’t generally offered by commercial lenders.
What is a variable closed-rate loan?
A variable closed-rate loan has a variable rate, but with fixed monthly payments. It’s effectively a floating blended payment loan. Such types of loan are sometimes available for residential mortgages, but they’re generally not offered to commercial borrowers.
Do all loans have a choice between a fixed and variable rate?
Yes, this is the case at BDC.
Does BDC offer any types of loans other than fixed and variable-rate loans?
No, they’re all either fixed or floating.
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