Managing your business through a rising interest rate environment is challenging at the best of times, but when you combine rising rates with rising inflation – it’s a double whammy.
DEROTTO consults with dozens of businesses every month and many business owners have most of their financing under a variable interest rate structure. In today’s climate, understanding your interest rate structure is more relevant than ever.
A variable interest rate loan is a loan where the interest rate is linked to the prime rate and subsequently fluctuates as the prime rate goes up or down. For example, a loan with a prime rate plus 2% equation means that at the start of 2022, this equation equaled 4.45% (2.45% prime rate + 2% = 4.45%), but as of the end of July 2022, this equation equals 6.70% (4.70% prime rate + 2% = 6.70%). Obviously, this translates to higher monthly loan payments.
When interest rates are flat or declining, then a variable rate loan makes a lot of sense. But when interest rates are rising like they are now, a variable rate loan is a lot riskier. A rising interest rate environment makes it challenging for business owners to manage their costs. To help combat this, business owners should seriously consider converting as much of their financing to fixed interest rates – At least during this market fluctuation. Fixed interest rate loans lock the monthly payment to a set dollar amount each month. Your costs are predictable and having predictable costs during rising inflation and a rising interest rate environment is critical.
DEROTTO only provides fixed-rate equipment financing, be it leases or loans - your monthly payment is fixed and doesn't fluctuate with rising interest rates during the finance term.
Typically, variable interest rate financing is associated with lines of credit, and fixed interest rate financing is associated with term loans. One reason businesses get into financial trouble is when they use the wrong type of financing. At DEROTTO we are constantly telling business owners that “not all financing is treated equal”. This especially rings true when acquiring major hard assets (like equipment), or soft assets (like inventory management software).
One of the big differences between variable and fixed rate financing is the monthly payment. The monthly payment for a variable rate loan often has no term and only requires paying “interest only” with no principal payment down. The monthly payment for a fixed rate loan has set monthly payments, term, and the monthly payment is a combination of interest and principal.
Too many business owners use a line of credit to acquire major assets. Business owners always have the greatest of intentions to quickly pay off a large “line of credit" purchase, but don’t have the discipline to follow through. A line of credit is typically used for working capital or as an emergency fund. If a line of credit is tied up with a large purchase, like an excavator, then if the company gets into a financial bind, it doesn’t have access to funds to help maneuver through a financial bind. DEROTTO hears of business owner’s struggling with this scenario almost daily. Don’t get caught yourself!
All indications show that interest rates will continue to rise in Canada over the next 12 months and managing rising interest rates is crucial to your business.