Fixed or variable rate: which should your business loan carry?

How a bank arrives at a fixed rate

Banks mostly fund themselves at rates that move: deposits and wholesale borrowing reprice as market rates change. A bank that lends at a fixed rate for five years takes the risk that its own funding costs rise underneath the loan. So it prices that risk away, in one of two ways.

• Off the swap market. The bank looks at the swap rate for the loan's term, the rate at which floating payments can be exchanged for fixed ones, and adds its credit spread. Often the loan itself is written at a floating rate and the borrower signs an interest rate swap that turns it into a fixed payment. The result is called a synthetic fixed rate; the bank usually hedges its side with a matching trade.
• Off its internal funding curve. Many community and regional banks set a transfer price for money of each term, their own cost of funding a five-year or ten-year fixed loan, and add the spread for the borrower's credit. No swap is signed, but the bank's cost of fixing still reflects the market's rates for that term.

Either way, the fixed rate is built from what the market expects floating rates to average over the term, plus a premium for the bank's risk. When markets expect rates to fall, a fixed rate can come in below today's floating rate; when they expect rates to rise, it will be above it. That is why choosing fixed or floating is not really a bet you can win by reading the news. The market's forecast is already in the price. What you are choosing is whether to accept that forecast as your cost, or carry the risk of the actual path yourself.

How a variable rate resets

A variable rate is an index plus a spread. The index is usually SOFR, the Prime rate or, on some bank loans, the bank's own base rate; the spread reflects your credit and stays fixed unless a pricing grid moves it with your leverage. The rate resets on a schedule, commonly monthly or quarterly, and the payment is recalculated. Many floating loans carry an interest rate floor, a minimum index level, so the rate cannot fall below a set point even if the index does. For how the two main indices compare, see SOFR vs Prime-based loans and what SOFR plus a spread means.

SBA 7(a) loans may be fixed or variable, and SBA caps the variable rate at the base rate plus a spread that falls as the loan grows. See the maximum SBA 7(a) rate and current figures on SBA loan rates.

Side by side

What a rate rise does to your coverage

Lenders test your ability to pay with debt service coverage: cash flow available for debt service divided by a year's principal and interest. On a floating loan, a rise in rates raises the interest and nothing else, so coverage falls with no change in the business.

Take a business with 1,000 of cash flow available for debt service and a term loan whose annual principal is 450 and interest 350. Debt service is 800 and coverage is exactly 1.25x, the level conventional bank lenders commonly look for. If rates rise enough to lift the interest to 500, debt service becomes 950 and coverage falls to barely above 1.0x: below the 1.15x SBA minimum and well below a 1.25x covenant. The business did nothing wrong; the index moved.

Turn that around and you have the test that decides the question. Divide your cash flow by your covenant level to find the most debt service you can carry, then subtract today's debt service. What is left is the interest increase you can absorb. In the example, 1,000 divided by 1.25 is 800, and the loan already costs 800: there is no room at all, so the loan should be fixed or hedged. A business with 1,200 of cash flow and the same loan could carry 960 and absorb 160 more interest a year, which is a real cushion. See how much covenant headroom to negotiate.

The right question is not where rates will go. It is how far they could go before your coverage breaks, and whether you could live with that.

Leverage magnifies all of this. In an acquisition loan or a refinancing near the lender's limit, interest is a large share of each payment, so the same rate move takes a bigger bite out of coverage. That is why lenders often require a hedge on highly levered floating-rate term loans; see when lenders require a hedge. Remember too that a line of credit is almost always floating, so a business with a floating term loan and a drawn line has more rate exposure than the term loan alone suggests.

The price of a fixed rate: getting out early

Certainty on the way in usually means cost on the way out. A bank that fixed your rate has hedged or funded itself for the full term, and if you repay early it wants to be made whole.

• Yield maintenance charges roughly what the lender loses by reinvesting your money at today's lower rates. It can be large when rates have fallen, which is exactly when you would want to refinance.
• Step-down penalties charge a set, declining share of the amount prepaid in each early year, regardless of rates. See yield maintenance vs step-down prepayment.
• Swap breakage applies to a synthetic fixed rate. Ending the swap early settles its market value: if rates have fallen, you pay; if they have risen, the swap may be worth something to you. The loan can be prepaid while the swap is broken separately, at its own cost.
• SBA's rule applies to 7(a) loans of 15 years or more, fixed or variable: prepaying more than 25% in any of the first three years costs 5% of the prepaid amount in year one, 3% in year two and 1% in year three. See the SBA prepayment penalty.

A floating-rate bank loan, by contrast, can usually be repaid at par, though private credit loans often carry call protection of their own. If you expect to sell the business, refinance or pay the loan down from excess cash within a few years, count the exit cost before choosing fixed. The arithmetic for a refinance is in the refinancing break-even.

The middle ground, and how to decide

The choice is rarely all or nothing. A loan can be fixed for its first several years and then reset or float. A floating loan can be paired with a swap on part of the balance, or with an interest rate cap that pays you if the index rises above a strike, leaving you free to prepay; see swap vs cap. Many borrowers fix or hedge enough of the debt to keep coverage safe under a severe rate case and leave the rest floating.

• Headroom. Run the coverage test above at the current rate and under meaningfully higher ones. If a plausible rise breaks your covenant, fix or hedge.
• Holding period. If you will likely repay within a few years, the flexibility of floating is worth more and a fixed rate's exit cost weighs more.
• How the business behaves. Some businesses raise prices when rates and inflation rise; others, such as those tied to construction or big-ticket customer purchases, slow down. A business that suffers when rates rise should not also let its loan payment rise with them.
• Total floating exposure. Count the line of credit and any other floating debt, not just the new loan.

Offers from different lenders often differ as much in rate structure as in rate. Transparent's lender package includes a financing model with rate sensitivities, so each lender, and the borrower, sees coverage at the offered rate and under higher-rate cases before anything is signed. The book holds 1,148 lenders that write term and private credit and 278 that write SBA 7(a) and 504, which lets fixed and floating offers be compared on the same file. See how we underwrite.