Wednesday, February 6, 2013

Fire Truck Interest Rate - fixed or variable?

Recently, there have been a lot of fire departments accepting variable rates.

It's important to understand the financial risks you are taking when choosing a variable rate.


Variable rates are attractive because they are lower than fixed rates.  So, the payment is lower upfront which is attractive to a lot of departments.

Banks offer variable rates because interest rates are so low and they are reluctant to commit such a low rate to a customer for longer term financings such as fire trucks.

What are the risks?

The biggest risk is call "rate risk".  It's the potential problem of paying higher rates in the future as the overall market rates go higher.

How to analyze rate risk

It's simple to explain yet hard to calculate.  It's important to find the breakeven point where future higher rates cost more than the benefit of the lower rate early.

The amount of the rate increase is as important as the timing of the increase.  For example, if rates rise immediately, you will pay more interest lowering the breakeven point.  If rates stay low until the lease is almost paid off, the breakeven will be higher.

Summary

The general rule of thumb for borrowers is to lock in fixed rates when rates are low and choose a variable rate rate when rates are high.  In other words, just the exact opposite of what departments are doing now.

Banks understand interest rate risk better than you and they are trying to pass it off to borrowers.  That should say something.

Stay safe!
John R. Hill
First Bankers
FirstBankers.net

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