Financing and Leasing When Rates are Rising — 3 Best Practices

2022 has been the year of rate increases. Rates have been going up all year, including an unprecedented four consecutive 75 basis point increases.

Because nearly all successful companies utilize credit and financing/leasing as a standard part of their operations, it has caused concern across all industries, with executives wondering when rates will stop rising and return to previous lows.

To address these questions, here are some thoughts on rate increases and a few best practices for companies that need to borrow in this higher-rate environment.

How Long Will Rates Continue to Rise?

This is the No. 1 question companies are asking. And the truth is, the answer is a vague “nobody knows.” The Federal Reserve has been raising rates to address runaway inflation, and the general consensus is they will not stop rising until inflation peaks, holds steady, and then falls. But inflation has proven resilient.

So, we’re left with trying to interpret the cryptic statements “the Fed” makes while also logically looking at the situation. The Federal Reserve has indicated that while they are perhaps finished with the concurrent 75 basis point increases (we hope), they are nowhere near the end of rate increases. And while nobody has a crystal ball, most commercial lenders feel rates will keep rising and stay elevated well into the foreseeable future.

This means it is unlikely we will see rates fall back to pre-2022 levels for quite some time. It also means that whatever the rate is “today” (whenever “today” is) will likely be the lowest rate available for the foreseeable future.

Best Practices for Borrowing When Rates are Rising   

Because using credit is a standard business practice for companies wanting to stay competitive, it is advantageous for them to get the best terms possible, especially in a higher-rate economic environment. Here are some best practices companies can utilize when using credit which can save them a lot of headaches in the future.

• Best Practice: If You Need to Borrow, Don’t try to Wait out Rates

Many companies pull back when rates go up, delaying improvements, upgrades, and launches until rates fall again. But as mentioned earlier, rates are likely to keep rising. This means companies are likely to pay an even higher rate when finally forced to borrow.

Anecdotally, this was on display for my company earlier this year. A client was purchasing needed equipment, and while they were in the final stages of choosing between two different models, they inadvertently missed the first 75 basis point increase. This caused them to panic, and they almost pulled the plug on the purchase. Their exact words were “we lost out.”

However, they thought about it, decided they truly needed the equipment, and went ahead with the purchase. It proved to be the right decision. They got the machine they needed while locking in a rate before several more increases. In reality, they “won.” And looking forward, so did any company who locked in a rate any time in 2022.

This same scenario is likely to play out again and again in the months ahead.

• Best Practice: Choose an Advantageous Loan or Lease Structure

When choosing a loan or lease structure, most SMEs will find a fixed-rate Equipment Financing Agreement (EFA) to be the most advantageous. Getting a fixed rate is a hedge against future rate increases, and the EFA (which is essentially a straightforward loan) allows the company to take a Section 179 Deduction on the equipment, which is very desireable.

There are several scenarios where an Operating Lease may be preferred, but these are typically favored by public companies looking to keep the equipment off the balance sheet, either to avoid board approval for new assets or to be more attractive to investors. An Operating Lease can also be used to keep debt-to-asset ratios low to avoid violating bank covenants on existing loans (more on this in a moment). An Operating Lease can also be useful if a company is only looking to use the equipment for a short period of time (i.e., almost akin to a rental).

However, with an Operating Lease, no Section 179 deduction can be taken, which is a major drawback for most SMEs. Hence the EFA making the most sense in a majority of scenarios.

• Best Practice: Be Aware of Restrictive Covenants and Liens

Some lenders (including nearly all banks) utilize multiple covenants and liens when lending to businesses. These include blanket liens, minimum bank balance requirements, and insisting companies “requalify” for the loan annually (this is where the debt-to-asset ratio can come in.)

These covenants can severely impact operations, as a blanket lien and minimum balances can tie up a company’s assets for years, and annual requalifying can keep a company from acquiring new assets. In a bit of irony, these restrictions typically accompany the lowest available rate. And as rates rise, the likelihood of companies shopping for the lowest rate increases.

The best practice is to ask about covenants and blanket liens before borrowing and be 100% certain they are both clear and acceptable. Even in a higher rate environment, an extra point of interest may be desirable if it eliminates covenants that tie up assets for years.

Wrapping Up

Higher rates will likely be with us for the foreseeable future. But most companies still need to use credit to stay competitive. By utilizing a few best practices when borrowing, companies can better navigate this higher rate environment.

www.crestcapital.com

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