Gentlemen: Start Locking in Your Interest Rates

David Perkins

Interest rates are at a historic low, as you can see in the accompanying chart. It is not easy to predict the future, but change is certain … and if interest rates are going to change, the only way for them to go is up. So, you should consider protecting yourself and your business from the coming rise in interest rates.

If you want more evidence that rates may be rising, listen to the comments being made by the chairman of The U.S. Federal Reserve, Alan Greenspan. The Federal Reserve sets interest rates. They are poised to raise rates and the chairman is telling us all to prepare. Why does he warn us? Because he wants order in the financial markets and in economy. He doesn’t want the world to go into shock when the Fed makes a move.

Here are some things to consider:

Convert Variable Rate Debt to Fixed
If you have debt outstanding, consider locking in the lowest rate possible. This means, if you currently have debt on which you pay a rate that changes as the prime rate changes, talk to your lender about re-booking the loan at a fixed rate. You will pay a slightly higher rate but what you owe in monthly interest expense will not change. This will help you with budgeting and you will be protected from rate increases.

Credit card debt is variable rate debt … usually at penalizing high rates. You should always make great efforts to avoid credit card debt. If you carry a balance, talk to your local bank as to whether they can pay off your credit card(s) for you in exchange for a loan at more reasonable, fixed rates of interest.

Refinance Fixed Rate Debt
If you have fixed rate debt at a rate that is two percentage points above the rate that you could today obtain by refinancing, look into it. The table below shows how the change in interest rates can affect the annual interest expenses paid on a loan.

Over the life of a loan, the interest rate impact is even more significant. For example, a two-percentage-point interest savings on a $100,000, 25-year mortgage is $39,000 over the life of the mortgage.

Pay Attention to the "Terms" of Debt Financing
In evaluating loan options, there is more to consider than the interest rate. Up-front expenses such as "points," closing costs and even legal fees must be evaluated. When evaluating loans with varying terms, one must find a way to compare them. The method is to calculate the "effective rate of interest" as opposed to the stated rate of interest. The most common approach is to total up all the non-interest costs of the loan, divide the total by the number of months of the loan, and then add this monthly amount to the monthly loan payment. This yields your effective monthly loan payment from which you can calculate your effective interest rate.

If this is confusing, call your banker, financial advisor or math teacher-neighbor. There is also an "Effective Interest Rate of a Loan Calculator" in the members only section of the The Business Owner website (www.TheBusinessOwner.com). Enter the subscriber password, which is always located at the bottom of the left hand column of page four of each issue The Business Owner.

To illustrate, the below two tables display the effective rate calculations for various points paid on loans with five year and 25 year amortizations. One point is simply 1 percent of the loan value. So, for a $100,000 loan, two points is $2,000.

Comparing the two effective interest rate tables, one can see that up-front expenses have a far more substantial impact on short-term loans compared to long-term loans. When points are required to "buy down" an interest rate, doing so is far more attractive when the loan term is long. Regardless, calculate effective rate on all your loans and you will be able to compare apples-to-apples.

Pre-Payment Penalties
Many loan terms include prepayment penalties. Calculating their affect can be tricky because they only come into play if you need to pay off the loan before its natural expiration date. This most often comes into play when interest rates fall and you wish to refinance. The chances of this happening to you on a loan you close today are slight, but you should consider this feature nonetheless. For simplicity, consider treating the prepayment penalty as if you were paying one point (i.e. one percent of the loan balance), and factor that into the effective rate calculation.