Interest Rates and Restructuring Debt

“Change is the only constant in life.” - Heraclitus

We have just emerged from a decade of ultra-low and steady interest rates. The environment that most of us are used to operating our businesses in has changed dramatically. How do we access debt and financing to continue growing our companies? How do we access debt and financing in our personal financial lives? The short answer is that we need to get more creative.

Financing structures

Most of our client-owned companies at Entrepreneur Aligned use some type of financing. Some of the most common financing structures are revolving lines of credit, term loans of less than 10 years and Small Business Administration (SBA) 7(a) and 504 loans.

There is significant variation between lenders on rate, term and provisions for each of these loan or line types. Most interest rates are determined based on underlying market interest rates, with the most common being the Wall Street Journal prime rate. That one finished 2021 at 3.25% and jumped to 7.5% a year later in December of 2022. So, any existing fixed rate loans you have are likely locked lower than what you could originate today. Any lines of credit have likely increased by 4% or so. I know at this point, you have likely rolled your eyes and said, “Yeah, I get it, capital is much more expensive today.”

Going forward

So what does this mean for options going forward? It means that you are likely looking to borrow for a shorter term and at a variable rate. Banks who carry the debt themselves (unlike most mortgage originators, who sell their loans to investors) are managing their risk just like the rest of us. If they are going to lend out capital for an extended time, they will likely add more margin to that loan than they would have between 2010 and 2021. As we all collectively watch to see where interest rates move next and at what point they inevitably move back down, shorter term financing will continue to be easier to procure, and rates will be more attractive.

What we look for to fund business expansion needs to change from the playbook we used during the past decade. Think about term loans with rate lock periods of less than three years instead of five to 10 years. Have multiple lenders bidding against one another and compare offers. For example, Lender A might be willing to do a loan with a 24 month fixed rate period at WSJ Prime + 2.5%, while Lender B may offer a 48 month fixed rate period at WSJ Prime + 4%. What best suits your needs, and where is your comfort level about refinancing that debt later on?

Loan costs

Loan costs are also likely to be more varied than they have been in the past. Each lender has their own balance sheet and objectives in building their loan portfolio. Some will emphasize near term cash through the origination process and some are looking for a larger amount of cash flow on the loans themselves. Because none of us have access to the internal priorities at each lender, it pays to solicit at least two or three proposals when using credit. Include up-front costs and loan covenants along with the rate and term to see what is going to fit your company best.

The personal side

On the personal side, our largest use of debt is typically for our primary and secondary homes. Take a look at adjustable-rate mortgages (ARMs) with the rate lock period matched to the amount of time you are likely to be in the home, and/or to when you expect outside capital to show up.

For example, if your youngest child is 12, you are likely looking for a six-to-seven year period on your mortgage, as you may elect to move once you have a smaller household. Similarly, if you think you will have a business exit event in the next three-to-four years, take a look at a five year ARM. Once you have additional outside capital, you can either pay off your mortgage, refinance at a better rate or do a lower loan to value ratio on a new loan.

Interest-only

Interest-only options can also offer a lot of cash flow flexibility, if you are in a period where personal cash flow is tighter. For example, you have opted to expand your management team in the business and take a lower owner distribution for the next two years, while growth catches up to your hiring pace. Doing an interest-only loan at a 1-2% higher rate on your home purchase would reduce the amount of your payment. You would have the option to refinance, once your owner distribution increases again. Similarly, when thinking about construction financing for a new home build, you would likely have a period of interest-only expense while the property goes through design, permitting and construction.

When interest rates were more stable, a common option was a construction-to-permanent loan, where only interest was paid during the construction phase. Upon occupation of the home, the loan would then convert to a fixed rate. Today, it likely makes sense to use a construction interest-only loan and then get a separate permanent loan at the end of the project.

Silver linings

Higher interest rates also carry some silver linings. One of the biggest is increased yields on stable value assets. Premium money market funds, municipal bonds and short-term treasury yields have all climbed into the 4% range again as of the time of this writing (early 2023).

This does not mean that your standard business bank accounts or personal checking and savings accounts have followed suit. Many banks continue to be awash in deposits and have not had to offer competitive rates. Be sure to see what your cash yields are, and move assets around to capture better returns on your reserves. Structure your reserves to match your time horizon needs just like your debt structure. Several months of cash can sit in bank accounts, the next few could sit in premium money market funds and months six through 12 could be in some type of short-term fixed income. Owning businesses requires holding significant cash positions. Make sure they are earning what they should. That possible extra 4% of yield means another $4,000 on every $100,000 you have in reserve each year.

Conditions have changed significantly around the cost of capital, interest rates and yields on stable value assets. We also know they will change again in the near future. Make sure you are reexamining how you use debt and credit and where you are keeping your reserves.

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DISCLOSURE: Jarrod Musick is an officer of Destiny Capital and Entrepreneur Aligned, a DBA of Destiny Capital. This article is for informational purposes only and should not be relied upon as a basis for your investment, business, or personal financial decisions. We recommend consulting with your wealth advisor, CPA/tax advisor and/or attorney, as applicable to your situation, prior to implementing any new tax, legal, or investment strategy.

ABOUT JARROD

Jarrod was born into financial planning and solving financial problems. With his financial advisor father Steve telling stories about finance around the dinner table from an early age, the idea that everyone has a different financial situation was always there. After an early professional career spent in nonprofit and government, Jarrod came back to his roots helping people plan and invest in 2011. Since then, he has worked with individual clients, led internal teams and ultimately became partner and the CEO of Destiny Capital in 2017. With a passion for helping entrepreneurs change the world, Jarrod ultimately oversaw the creation of Entrepreneur Aligned in 2020. With both Destiny Capital and Entrepreneur Aligned, Jarrod leads teams that help people live lives of abundance where money is simply a tool to let everyone be a positive force for the world around them. When he isn’t working with the talented teams for EA and DC you can find him chasing his twins, wily trout or a podium spot at an OCR race.