Get Ready for Higher Interest Rates

The Federal Reserve recently raised its benchmark interest rate by 0.75%, the biggest increase since 1994. The interest rate is still low by historical standards, with the fed rate now at 1.75%. But there is a lot of talk among economists that the fed rate will likely increase to as much as 3.5% this year and possibly 4% next year.

The federal benchmark rate is the rate at which the Federal Reserve loans money to large banks, and the higher interest rates quickly permeate through the economy in the form of higher interest rates for commercial lending, car loans, mortgages, etc.

Refer to the graph below to see why I refer to current rates as still low. The federal reserve rate dropped to near to zero at the beginning of 2009 and has stayed incredibly low since then, other than a blip upward to 2.4% at the beginning of 2019. But the last time the fed rate was this low was in 1958, so the recent low rates have been an historical anomaly. After having enjoyed low interest rates for thirteen years, I think it’s obvious that most of the economy has come to take low rates for granted.

This is a particularly germane issue today because a lot of ISPs are considering borrowing large amounts of matching funds for broadband grants. Higher interest rates mean larger annual debt payments, and that can easily make the difference between a business plan being feasible and not feasible. For a new project to cash flow, the new customer revenues must be large enough to cover operating expenses plus the cost of debt.

Below is a simple table showing the annual debt costs for a $10 million loan – which would represent a 25% grant matching for a $40 million broadband grant project. Down the left are interest rates. Across the top is the loan term, in years. The values in the table are the annual debt payments. This makes it easy to grasp the impact of an interest rate increase. If you were hoping for a 15-year loan for $10 million at 4% and the interest rate increases to 6%, the annual debt payment climbs by $128,000.

Loan Term
Rate 10 15 20 25
3% 1,424,564 940,295 727,087 608,139
4% 1,485,278 1,001,437 789,933 673,091
5% 1,547,218 1,064,558 855,462 741,368
6% 1,610,359 1,129,601 923,565 812,785
7% 1,674,678 1,196,508 994,126 887,139

The chart also suggests the strategy to offset interest rate increases, which is to find longer-term debt. If that same 15-year loan at 4% can instead be financed for twenty years at the higher 6% interest rate, the annual debt payments would decrease by almost $78,000, even with the higher interest rate.

This is not to suggest that finding longer-term loans is easy. Most commercial banks don’t like making loans for longer than 10 or 12 years in length. There are specialty banks like CoBank and RTFC that will give out longer-term loans, but even they are not going to make long-term loans available to everybody. Most banks dislike tying up their equity in long-term loans.

The only group of borrowers that have a relatively easy time getting longer-term loans are municipalities. Federal bond law allows financing for terms up to the economic life of the assets being financed. I’ve routinely seen municipal bonds for fiber networks financed for terms as long as 25 or 30 years.

The bottom-line advice in a time of increasing interest rates is to make sure that you understand the implications for whatever project you’re thinking of funding. In past decades I can remember many times when increasing interest rates put projects on hold since they became impossible to pencil in. As you can see by the long-term fed chart, if you wait long enough, interest rates that go up will eventually come back down.

Unfortunately, grant projects are not going to allow borrowers to wait out a bad cycle of interest rates. You either take the higher-rate loan or you pass on the project. As an aside, the rising interest rates are another reason against asking for irrevocable letters of credit. Banks are not going to guarantee or lock in interests today if the money is going to be needed a year or two from now. An irrevocable letter of credit is worthless if the interest rate rises and the borrower can no longer afford the debt.

Economists have been saying for a number of years that interest rates need to return to the normal cycle. Much of the reason for low interest rates has been meddling b the government to force interest rates lower. But this return to normal rates couldn’t happen at a worse time for purposes of funding BEAD matching. It’s one more factor that is going to make accepting a big grant that much more expensive.

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