Should you cap the interest rate on your loan?

From a historical perspective, interest rates are at an all time low and the question is, are they likely to remain at this level or might they return to much higher levels, as in the 1970’s and 1980’s?

The short answer is that nobody can possibly know. Certainly, there does not seem to be much pressure for them to rise significantly at present as inflation continues to remain under control. Indeed we may have reached the top of the interest rate cycle, or at worst, there may be one smaller rise to come. However, that is a judgement made on the facts available now. What we don’t know is the unexpected.

Harold Macmillan was once asked by a journalist, what the most difficult situation was, that he had had to contend with when Prime Minister. His reply was; “Events dear boy, events.”

In other words, you can study all the economic and financial data available and make a reasoned and intelligent prediction of what is likely to happen but what you cannot know is the unknown. Therefore the answer to the initial question may well have been no, on a balance of probabilities, now is not the time to lock into fixed rates or buy a cap because interest rates are more likely to remain stable or even go down over the next year or two. Therefore the purchase of an interest cap would be an unnecessary expense.

However, if you view the question from the same angle as you would have done if the question had been about whether you should buy fire insurance over your house or not, then you would almost certainly answer yes, even though on a balance of probabilities, taking into account all the facts, it is unlikely that your property would be destroyed by flood or fire… but it just might and if it did you might end up bankrupt, certainly your wealth would be seriously affected.

Therefore, you should view the issue of interest rate hedging as a form of insurance to cover events which, although unlikely to happen, just could happen and if they did, might have serious consequences for your business.

So, look at your borrowing and calculate the level that interest rates would need to reach before they started to have an unmanageable effect of your cash flow. This will differ from business to business and be quite dependent upon the inherent strength of the cash flow and the level of the gearing within the business. i.e. the level of borrowing in relation to the income producing assets of the business. After all, £5m is a significant amount of borrowing for a small business and could make it vulnerable to a rise in interest rates but to a multinational it is a much less significant sum and any rate rise would have much less effect.

When we are assessing applications for finance within Statim, we have a built in ‘what if’ in the cash flow forecast, which shows the effect that an interest rate of 3% above the current level, would have on the business.

Once you have calculated the risk level of interest rates, then you can contemplate some interest rate hedging, which might be only for part of the borrowing and perhaps for what might be considered to be the risk period. i.e. until the business has established itself; perhaps the first two or three years of the loan. It certainly does not have to be for the entire period of the loan. The higher the cap level is set and the shorter the period, then the lower the premium is likely to be. Your bank will be able to supply you with quotes upon request.

In summary therefore, view interest rate hedging as a form of insurance, which you might never have to call upon but which is there just in case. The fact that you have it will enable you to sleep soundly at night!