At some point in your business’s future, you might want to get a small business loan. When that time comes, you may have to choose between a fixed-rate loan and a floating-rate loan. Fixed-rate loans have the same interest rate throughout the life of the loan, while floating-rate loans have an interest rate that can fluctuate over time. Floating rate loans are also called variable-rate loans and adjustable-rate loans.
In Canada, the base interest rate for floating-rate loans is the prime rate. The prime rate is the interest rate that large financial institutions and commercial banks charge their most creditworthy customers to lend them money. The institution that is lending you money uses this base rate and then adds on some additional percentage points to cover the fees associated with the loan and the overall risk that you may default. For example, assume the Canadian prime rate is 3 percent. An institution that lends money decides that 5 percent is a reasonable interest rate to charge customers for a loan. The floating-rate on this loan is calculated as 3 + 5 = 8 percent.
Now, assume that a year later, the prime rate gets reduced to 2 percent. This means that the interest rate on your floating-rate loan is now 2 + 5 = 7 percent. This can work in reverse, too. If the prime rate goes up, so does the interest rate on your floating-rate loan.
The pros of a floating-rate loan are that, in general, they have a lower starting interest rate than fixed-rate loans and they wind up costing you less money when overall interest rates are going down. The cons are that these loans can wind up costing more money in the long run if interest rates continue to rise. The loan’s interest rates can vary a lot, making monthly budgeting difficult. And calculating the tax-benefits on these loans can be hard.
A floating-rate loan is a unique tool to borrow money that might benefit you over time compared to a fixed-rate loan. Weighing the pros and cons of this type of loan is something you must do before deciding on what type of loan is best for your business.