Borrowing over long periods can help place a business on a firm foundation. But it can also expose it to risks if interest rates rise to levels that seriously affect its profitability.
Many businesses are counting their blessings that as a result of this recession interest rates have fallen to an all time low. Consequently, they are able to service their loan debt. Had interest rates remained at levels seen only eighteen months ago, many companies with significant levels of debt would have ceased to exist.
The media suggests rates may stay low or fall further in the short term, the reality is nobody knows for certain. Taking a longer term view indicates interest rates historically have been volatile. This affects the borrowing costs and profitability of businesses. In the late eighties, the base rate doubled from 7½% to 15% in a year. As a result, many good (but heavily-borrowed) businesses “went to the wall”.
There are various alternatives and all involve a degree of risk (including costs to break the agreement) which should be assessed carefully. These include:
• Fixed rates – you know exactly what your costs will be. Risks include paying a higher rate than the market variable rate if you get it wrong.
• Cap the interest rate – this is a form of insurance with an up-front premium. You limit the maximum rate to an agreed figure. The Cap will protect against higher interest rates but also allows you to exploit the benefit of lower rates.
• Sometimes, associated costs can be reduced if the Cap is combined with an Interest Rate Floor – a combination known as an Interest Rate Collar. A Floor means that you will forego some of the benefit of lower interest rates.