Introduction To Floating Interest Rates
In the last post we talked about pros and cons of fixed interest rates. When a fixed interest rate doesn’t fit the bill, the alternative is a floating rate. As promised, today we’ll talk about floating interest rates, some problems with them, and some suggestions for making them work better in your contracts.
Keeping in mind from the last post on fixed interest rates, the longer the amount of time between setting the rate and when interest actually gets charged, the greater the chances that interest rates at large will change.
Problems With Bank Rates and Publication Rates
Contracts usually set floating interest rates by reference to some widely available rate or index and then add percentage points to it. If you want to sound work on Wall Street, you can add basis points instead. I frequently see something like “the Prime Rate, plus 4%.” This works OK, until you ask questions like:
- Which Prime Rate? The Wall Street Journal’s Prime Rate? Bank of America’s Prime Rate? Chase’s Prime Rate?
- What happens if the Prime Rate source is no longer available?
Different sources offer different Prime Rates. There’s no guaranty that the Wall Street Journal’s prime rate will be the same as Bank of America’s. When Prime Rates differ and you have a dispute over which Prime Rate determines how much interest you owe, I think I know which one you’ll pick. And I think I know which one you’ll pick when someone owes you.
A lot of contracts get more specific. They identify a rate established by a specific bank or financial publication. I see the Wall Street Journal’s Prime Rate most often. But this has problems too.
Unless you’ve been cryogenically frozen for the past ten years, you probably noticed banks a lot of banks getting bought up by ever bigger banks and disappearing. Remember names like Barnett Bank, LaSalle Bank, Security Pacific Bank? And it looks like a lot of newspapers may not be around too much longer either. If the bank or publication that provides part of your interest rate formula, odds are there’s going to be a controversy about what, if any, rate replaces it.
The Federal Reserve’s Primary Credit Rate
So instead of picking a rate from a bank or publication that might disappear, pick something else. How about a rate that’s easy to find and isn’t going anywhere. What rate is that? The Primary Credit Rate charged by the Discount Window at the United States Federal Reserve Bank.
What is the Discount Rate? It’s the interest rate that the Federal Reserve charges on loans to private banks like Bank of America, Chase, and Wells Fargo.
- Why the Primary Credit Rate better?It’s well known and been around for a long time, before WWII.
- It changes with the times. But, unlike other frequently changing rates like LIBOR, it doesn’t change every day. So it’s easier to keep track of.
- It’s always easy to find, whether you’re looking for the current rate or past rates. Just go to the Federal Reserve Bank’s website.
- Of all the available banks whose interest rates you can choose from, the “Fed” is the least likely to get bought-up by another bank or fail and go out of business. And if the Fed does fail, you’re all going to have a lot more to worry about than how much interest you charge, or get charged, on late payments.
Some extra notes about using the Discount Rate:
- Because there are 12 Federal Reserve Bank Districts, pick the Discount Rate at the District that your Project is located in. The Discount Rate does not usually differ from District to District, but it just usually looks better in the contract to pick the District your Project is in.
- The Discount Rate is about as low as rates go. It’s usually about 2.25% below most Prime Rates. So if you setting an interest rate that floats by reference to the Discount Rate, you’ll want to pay special attention to make sure that you add the right amount of extra percentage points on top of the Discount Rate. It’s usually going to be more than the number of points you’d add to a Prime Rate.
- Because the Federal Reserve Bank changes the Discount Rate faster than state legislatures amend usury laws, you’ll still need to make sure that your floating interest rate can’t go above the maximums imposed by applicable usury laws. With the Discount Rate as low as it is now – 0.50% – that seems far fetched. But who knows where the Discount Rate will be when interest starts accruing under your contract.
If you’re dealing with a lot of money or a lot of time between when you set an interest rate in your contract and when interest may actually start getting charged, you should seriously consider a floating instead of a fixed interest rate. And if you decide on a floating interest rate, have it float off of an index or another interest rate that is easy to find and likely to be around when you need it, like the Discount Rate.