On June 13, 2018, the Federal Open Market Committee raised the targeted federal funds rate for a second time this year, marking five total increases since the beginning of 2017. In a conference after the meeting, Jerome Powell, chairman of the Federal Reserve, signaled that two additional increases were on the way this year, expressing confidence that the United States economy was strong enough for borrowing costs to rise without choking off economic growth.
After each rate hike, I get a handful of questions from bankers who are anticipating the needs of their business customers.
“What does this mean for long-term commercial mortgage rates?”
“How do I prepare my customers for higher interest rates?”
“Should I work with my customers to refinance their loans now?”
Here’s how I help them understand the interest-rate environment and impact to local business owners. Let’s start by breaking down short-term versus long-term interest rates.
The Fed controls the short-term market rates by setting the federal funds rate, the rate at which banks borrow from each other overnight on an uncollateralized basis. The latest five rate hikes have affected short-term variable rates, such as the prime rate, which immediately impacts the rate of credit card and line of credit borrowing for consumers and businesses alike. However, for installment loans used to purchase business equipment, for example, the impact of higher interest rates is minimal if you plan to pay off the loan fully in three to five years.
The market sets long-term interest rates, not the Fed. For example, 30-year mortgage interest rates have not risen as much as short-term interest rates. Long-term rate changes stem from collective expectations by the market, not by an individual committee or bond trader. As a result of nine years of economic expansion, long-term rates have slowly increased. While most don’t expect long-term rates to spike dramatically, the landscape is getting more complex.
According to Dr. Mike Knetter, economist and president of the University of Wisconsin Foundation, trade issues are the new wild card. “If cooperation breaks down with allies on trade, this might have implications for monetary policy coordination and create instability in exchange rates. If tariffs increase and the dollar were to weaken due to U.S. isolationist moves, that puts upward pressure on prices and would force the Fed to hike more aggressively.” The long end of the yield curve would respond, too.
How should a business respond to higher interest rates?
For businesses with an existing commercial mortgage loan that is renewing in the next three to six months, it makes sense to talk to your banker and consider early renewal at current market rates. However, if your loan rate is locked in for the next one, two or four years, be very happy because your current rate is below the market rate. It may seem counterintuitive, but chasing rates is not necessarily always the best decision. As you decide the right move for your business, consider factors that contribute to the real cost of refinancing.
- Penalties: Review the terms of your loan to see if there are any pre-payment penalties. Particularly if you decide to refinance with a new bank, there isn’t any incentive for your current bank to waive those fees.
- Other costs: Especially if you refinance at a different bank, you’ll pay for an appraisal, title, documentation and filing activities associated with the loan, along with the additional time it will take. These costs may also apply at your existing bank.
Additionally, I recommend that you factor in the qualitative benefits of working with your existing bank, such as:
- The ease of working with your bank and banker.
- The knowledge your banker has about you and your company.
- The trust you have in your banker to lead you in the right direction.
Let your banker be a resource and guide as you plan for your company’s financial needs now and down the road. Ask for your banker’s view on interest rates and the impact on your financial position.
While you grapple with the costs of rising rates, also consider that operating in a higher interest rate environment gives well-run companies the opportunity to shine. From Dr. Knetter’s perspective, firms will need to be more discerning as they approach new projects to meet the higher rate of return, but this means they can also put pressure on marginal competitors. A higher interest rate environment could be a handicap for these firms on a relative basis, giving stronger firms an advantage.