Article

What Do You Mean U.S. Prime Rate Could Be 6%?

Posted by Melinda Toy on Nov 12, 2015 06:00:00 AM

Topic: ALL

Report of interest rates

One well-known interest rate index is the U. S. prime rate (prime). It has been 3.25% since December 2008. There are other indexes one could look at to determine historical rates and trends. Whichever one you choose, regarding U.S. interest rates, they are low and have been for the better part of 2008-15.

Low interest rates benefit companies that borrow. Ultimately interest is a component of a company’s cost of doing business. It is not as common today as it was 10 years ago for businesses to subject their projections or debt to interest rate sensitivity. Rates have remained low and moved very little. In the news there is more talk that the Federal Reserve will eventually raise rates.

What is the history of prime?

Prior to December 2008, the last time the prime rate was 3.25% was 60 years ago in August 1955. In between these two periods, it reached a high of 21.50% in December 1980 and was 5% in September 1959, where it did not go below 5% until October 2008. In fact since 1947, the cumulative average of the prime rate is 9.842%. The most frequent value is 7.5% and the median is 8.75%, all substantially higher than 3.25%. Interest rates will rise eventually. I don’t know when and I don’t know how fast, but they will increase.

It is best to take the time and give thought to preparing for a change in the prime rate, rather than reacting when the time comes. When rates are low, borrowing to expand the company can be very opportunistic. As interest rates increase, the cost of doing business increases. Customers may pay at a slower pace, and working capital borrowings might increase.

The economy does not behave in a linear fashion. The opportunity to increase prices might not be able to be passed on. Increasing costs is not desirable, but it is also not inevitable. Thinking about the impacts of interest on your business now is likely to result in a strategic advantage, not needless worrying. 

I do not believe most companies would need to be overly concerned about a prime of 3.5%, a 0.25% increase as of mid-2015. However, many business owners may not have thought about a 6.25% prime—a 3.0% increase. A 3% prime on a million dollars is $30,000. How significant is that to the profitability and cash flow of the operation? This may sound farfetched, but 6.25% prime was prevalent for many years and very well could be again.

Going into 2016, it may be a good time for business owners to review the company’s cost of debt and what its financing needs over the next few years. Obtaining a balance of fixed and floating rates that protect the profitability may well be a significant strategic advantage. What could it hurt to look at interest costs?

To learn more, contact one of our local Commercial Bankers.