Cut Your Financing Costs

With short-term interest rates going up, now's the time to trim financing costs by cutting back on adjustable-rate loans.
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6 min read

This story appears in the February 2006 issue of Entrepreneur. Subscribe »

Like any business owner, Jeff Samuelson never has cash flow far from his thoughts. "We want to be more liquid so we can be nimble in making decisions and not [be] locked into raising [money] to get something done, like funding a new product line or making other moves in the business," says the owner of Samuelson True Value Hardware and Lumber in Craig, Colorado.

Until recently, though, that was difficult because the business's cash flow was being squeezed by a hodgepodge of short-term, variable-rate loans--12 in all. Samuelson knew that consolidating those credit products, which ranged from equipment leases to commercial real estate loans, would help reduce financing costs. And with interest rates rising, the time had come to make the switch to fixed-rate financing. "We knew that if we didn't lock in the adjustable-rate loans, the interest rates would continue [to increase]," recalls Samuelson, 40, who owns and operates the $8.5 million business with his brother, Mark. "We knew we were going to save substantially [with fixed-rate loans]."

To that end, the Samuelson brothers recently consolidated the company's outstanding debt into a $1.4 million loan that has a fixed rate and a longer amortization schedule. "We improved the average rate we were at by consolidating into one loan," Jeff says. "We also improved the rate because of the [interest-rate] climate we're in now, whereas before, we had loans that we had [obtained] over the years at different times [and at higher interest rates]. I thought this was a good time to lock the rates before they continued to increase."

By refinancing, the company saw its interest rate decrease to 6.78 percent from an average rate of 7.8 percent, and it is now realizing a monthly cash-flow savings of $8,000. "When you're talking about loan amounts [of this size]," says Jeff, "a point or two can make a big difference."

In for the Long Haul
Interest rates have risen steadily since June 2004, when the Federal Reserve Board raised short-term interest rates for the first time in four years. This has led to a gradual but significant increase in the prime rate, which sets interest rates for floating-rate loans. "When interest rates are falling, a variable-rate loan is the way to go," says John Milbauer, president and CEO of Patriot Bank Minnesota in Lino Lakes, Minnesota. "But in a time of rising interest rates--where we are right now--anyone who has a variable-rate loan should be trying to fix the rate to make sure they have a handle on what their interest costs are going to be over the next several years."

In reality, though, some types of variable-rate credit cannot be converted into long-term, fixed-rate financing. That's because certain assets are simply too short-term in nature. Cases in point: inventory and accounts receivable. "Banks aren't too keen on giving you a long-term loan on an asset that's going to potentially disappear during the term of the loan," says Scott Page, executive vice president of Vectra Bank Coloradoin Denver. "[A lender] wouldn't do a revolving line of credit to support inventory and receivables as a three-year loan because those receivables and inventory turn over so quickly."

In for the Long Haul

As a result, many short-term credit consumers have little choice but to absorb the higher interest costs. However, some entrepreneurs also tap those floating-rate lines of credit to fund lengthier capital commitments like buying equipment--a costly financing strategy in today's interest-rate environment. "Occasionally, businesses will have a line of credit and do all sorts of things with the line, not just support their working capital," Page explains. "They'll actually go out and buy a forklift or a dump truck or whatever [equipment] they need."

Fortunately, firms can often transfer those assets to a longer-term loan with a fixed, more favorable interest rate. "Say you had a $500,000 revolving line of credit and [you] used $100,000 to buy capital equipment. You could take that $100,000 out from that revolving line and ask for a separate loan to term it out," Page suggests. "You could then repay it over a three- to five-year period, and at today's rate, that would be a really smart thing to do. A working capital line should support short-term accounts receivable and short-term inventory, and as [you] collect the receivables and sell inventory, the proceeds are supposed to be used to pay the loan back down."

No Knee-Jerking
While business owners are understandably anxious about rising interest rates, experts warn that making a strategic decision--such as whether to upgrade an outdated facility-based only on interest rates can have dire consequences. "If your business is nonproductive due to an obsolete or [undersized] facility, moving to an appropriately sized building to maximize production is always going to be beneficial to the business in the long run. If the business has goals of doubling its sales, but the [current] facility is only capable of producing the sales volume they're at right now, they need to look at expanding," Milbauer advises. "I don't think any business should ever [consider] adding equipment or [make a] decision to grow into a larger facility based on interest rates."

By the same token, commercial borrowers should carefully examine any refinancing deal to determine the actual cost savings. That's because the loan may contain a prepayment penalty clause, which states that if your loan is paid off within a specified period of time--often in the first three years--the lender will charge you a fee. For example, if your loan has a three-year prepayment penalty, the amount of the penalty may be 3 percent of the loan balance if it is paid off in the first year, 2 percent in the second year and 1 percent in the third year. "Before making any kind of a move to refinance, you need to scrutinize the loan documents to see if there is a prepayment penalty," Milbauer cautions. "You [should then] factor in the amount of the prepayment penalty vs. any interest savings to see where the break-even point would be."

Experts agree that you're more likely to get a better deal overall if you solicit proposals from several creditors, not just from your regular lender. Says Page, "The banks are hungry to keep their good assets, so there is a lot of competition among banks. A good, savvy business owner will talk to more than one bank. It's just smart."

Jeff Samuelson concurs: "We had gone to a couple of banks and kind of [reached] dead ends. [The banks] may not have understood the loan fully. We had to get the information to the right banker. And once that happened, everything popped for us."

Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.
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