18 Sep Should You Choose a Variable or Fixed Rate Asset-Based Loan (ABL)?
Choosing between a variable or fixed rate for your asset-based loan (ABL) is a small decision that significantly impacts your business. The type of interest rate directly affects your monthly cash flow, long-term cost of borrowing, and ability to weather future economic shifts. Making that choice is more important than choosing accessories for your outfit, but the process is the same.
When you consider which jacket and shoes to pair with your outfit, your choice depends on the context. You will pick different jackets for winter or spring, a first date or second interview, and inside or outside. Once you know that it’s a first date on a hike in a relatively humid and warm spring, you can dress for success relatively easily.
Deciding the type of interest rate on your ABL becomes much easier when you use a similar decision-making process.
Understand the difference between a fixed and variable rate, the factors to consider, and the experts to consult to understand the context. Then confidently choose the interest option that sets your business up for success.
What Is an Asset-Based Loan?
Asset-based lending (ABL) is a type of financing secured by collateral. You might use inventory, accounts receivable, marketable securities, equipment, real estate, and even intellectual property. Lenders typically offer a business term loan or a line of credit based on the value of your assets.
ABL is popular among businesses with valuable assets but limited cash flow or credit, like a small floral delivery service with two vans and a small monthly margin. Because you’re offering tangible assets, lenders can be more flexible with their approval and terms.
This type of financing could be used for a variety of options. Asset-based equipment financing could finance bulky machinery or vehicles in your long-term expansion plans. Business asset loans could cover short-term operational expenses or fund a bulk inventory purchase at a discount.
What is a Fixed Interest Rate?
A fixed-rate loan means your interest rate stays the same for the entire term. Your monthly payments won’t fluctuate, which makes budgeting easier and protects you if interest rates rise in the future. This financing is ideal if you manage tight cash flow, operate in an uncertain environment, or plan to repay the loan over a longer period.
Let’s say you take out a five-year asset-based loan to upgrade your manufacturing equipment. Since you need to plan for the payments in the long term and your industry is easily disrupted, a fixed rate is a safe choice. The stable repayment amount brings you peace of mind and accurate planning.
A fixed rate may start slightly higher than a variable rate because your lender assumes all the risk for any changes in interest rates. For example, your fixed rate might begin at 9%, while a variable rate starts at 8.73%. The higher cost can be worth it when your business needs stability.
What is a Variable Interest Rate?
A variable rate has two parts: a margin and an index rate. When your loan is approved, your lender locks in your margin, which looks like an extra percentage on top of the benchmark interest. The index rate changes over time based on a benchmark index like the Prime Rate or SOFR. Your variable interest rate might look like SOFR plus 3%.
Because you share the risk of market changes with the lender, they offer lower interest rates initially and can save you money upfront. A variable rate on an ABL might suit you if you have the cash flow to handle fluctuating monthly payments and plan to repay the loan quickly enough that the index rates can’t change too much.
Suppose you leverage your existing inventory to secure a variable-rate ABL for $10,000. You set an 18-month repayment term and invest the funds in holiday inventory for your retail store. Since you will pay off the loan before rates change too much, you will enjoy lower interest costs than a fixed rate and save a couple of hundred dollars. The money saved can be worth the uncertainty, depending on your business needs.
How To Choose Between Fixed and Variable Rates
When you grab a pair of shoes to complete your outfit for the day, you’ve already considered the context and decided hiking boots will be the best choice. Now that you know the interest options, you need context about your business in the following four areas to make an informed decision.
1. Cash Flow Stability
A fixed or variable rate could be the difference between affording your ABL and missing payments. Each business has different rhythms, and your interest choice should reflect how your operation earns and spends money throughout the year.
A fixed-rate offers security if your business runs on tight margins or experiences seasonal fluctuations. For example, say you secure an asset-based line of credit for your lawn care business. The predictable payments make budgeting easier, which can be crucial during slower months. A fixed interest rate matches your business rhythms.
Other business cycles may work better with a variable rate. Say your energy company consistently sees an increase in revenue when benchmark interest rates increase. A variable rate would capitalize on your specific rhythm.
Regardless of your cash flow cycle, a business with sufficient monthly income to cover reasonable increases in your repayment amount or a significant cash reserve to account for any sudden interest spikes could save money with a variable rate. The reward depends on what you can afford.
2. Economic Outlook
A variable rate puts you at the mercy of the economy, just like your outfit is at the mercy of the weather. The best way to dress and finance for success is to check the forecast and prepare yourself accordingly.
Before committing to that interest rate, review economic predictions and watch benchmark rate trends. If rates are at their lowest point in years or currently rising, a fixed rate protects your repayment amounts. A variable rate only saves you money if rates are stable or expected to drop.
Market changes are specific to your industry and region, just like the weather report in Maine doesn’t help for your date in Arizona. You need a local expert. Say you are considering an ABL for your furniture business in Gary, Indiana. Work with a Chicagoland nonbank financier for manufacturing businesses to gain better insight about the relevant economic outlook than a national credit union specializing in mortgages.
3. Loan Duration
Interest rates typically change slowly over time. The shorter your repayment term, the less likely your rate will rise significantly. A variable rate is relatively predictable and cost-effective if your loan term lasts less than three years.
On the other hand, fixed rates typically offer more control for long-term commitments. Let’s say your healthcare clinic uses a long-term ABL to purchase new diagnostic equipment. You will repay the loan over the next seven years, which means the interest rates are impossible to predict accurately. A fixed-rate ABL gives you manageable payments for long-term success.
4. Risk Tolerance:
As the one responsible for your business and ABL, your personality and management style play a bigger role than you might think. When your business needs and current market conditions allow you to choose either interest option, the choice comes down to your risk tolerance.
Suppose you are comfortable with some uncertainty in exchange for potential savings and are willing to adjust your financing plans based on economic conditions. In that case, a variable interest rate is a good choice. If you value predictability in your business and would rather rely on your financing during market uncertainty, then a fixed interest rate will better match your risk tolerance.
Choosing an option you’re comfortable with is as vital as choosing shoes that fit your feet. Hiking boots might seem to make the most sense for walking up a mountain, but not if they’re three sizes too big. You are the one who has to deal with the sores, just like you are the one who has to make the loan repayments fit into your overall business plan. Pick the type of rate that will make it easier for you and your company.
Talk with Your Lender
Choosing a fixed and variable interest rate doesn’t have to be a one-person process. You can ask trusted and experienced people to help you make your decision. The best person to talk to is your lender.
Ask questions like:
- How often does the variable rate adjust?
- What is the benchmark used for rate changes?
- Is the index rate at a record high or low?
- What direction is the benchmark rate trending currently?
- Are there caps on how high or low the rate can go?
- Can I refinance the loan if market conditions shift?
In addition to answering your questions, your business loan broker can provide specific information about interest rates on their asset-based loans. They can walk you through simulations and side-by-side number comparisons for both options. Once you have the details, you can choose the interest rate you need.
Informed and Personalized Choice
Deciding between a variable or fixed rate on your asset-based loan or between a red double-breasted blazer or a black windbreaker with a hood is about matching the context. Neither option is bad. A fixed rate offers security, while a variable rate offers savings. But an informed and personalized financing decision makes it easier to succeed.