What it means
Rates begin with central bank policy, and almost everything else prices off that base. When the policy rate falls, business loan rates, mortgages and corporate bond yields generally follow, and the cost of carrying debt drops across the whole economy.
The effect on company decisions is direct. A project earning 6% is worth funding when debt costs 3% and destroys value when the same debt costs 8%, so the pipeline of viable investments widens and narrows with the rate.
What really matters is the real cost, meaning the nominal rate minus inflation. Borrowing at 3% while prices rise at 5% means repaying with money worth less than the money borrowed, an effective real rate of -2%.
Cheap money inflates asset prices as well as investment. Lower discount rates raise the present value of future cash flows, which lifts share prices, property values and the multiples buyers are willing to pay for businesses.
The hangover arrives when rates normalise. Debt taken on at 3% has to be refinanced at whatever the market offers years later, and businesses that treated the cheap phase as permanent can find interest swallowing most of their operating profit.
In practice
Real-world examples.
Example
A property developer fixes a $12,000,000 loan for ten years at 3.5% during a period of very low rates. The fixed cost of $420,000 a year later looks like a bargain against new lending at 7%, and the loan itself becomes an asset when the site is sold.
Example
A buyout firm pays 12 times earnings for a manufacturer, funded largely with debt at 4%. When the cost of that debt reaches 9% at refinancing, the same deal no longer clears the fund's return hurdle and similar transactions stop appearing.
Example
A retailer refinances a $20,000,000 bond issued at 2.5% into a new issue at 7.5%. Annual interest rises from $500,000 to $1,500,000, and the extra $1,000,000 forces the closure of a dozen marginal stores.
Formula
Calculation
Real interest rate = nominal interest rate - inflation rate
Annual interest cost = amount borrowed x interest rate
A distribution company borrows $5,000,000 to buy a warehouse. At a 3% rate the annual interest is $5,000,000 x 0.03 = $150,000, while at 8% it would be $5,000,000 x 0.08 = $400,000, a difference of $400,000 - $150,000 = $250,000 a year.
With inflation running at 5%, the real cost of the 3% loan is 3% - 5% = -2%, so in purchasing power terms the borrower is repaying less than it received. Across a five year fixed term the business saves 5 x $250,000 = $1,250,000 of interest compared with the 8% alternative.
The trap appears at refinancing. If $4,000,000 is still outstanding when the loan is refinanced at 8%, annual interest jumps from $4,000,000 x 0.03 = $120,000 to $4,000,000 x 0.08 = $320,000, an extra $200,000 a year that has to come out of the same operating profit.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Halberd Storage, an invented self storage operator, borrowed $30,000,000 at a fixed 3.2% for five years to buy eight sites. Interest of $30,000,000 x 0.032 = $960,000 a year sat comfortably under operating profit of $2,400,000, giving interest cover of $2,400,000 / $960,000 = 2.5 times.
When the loan matured, the market had moved and the best refinancing offer was 7.6% on the $27,000,000 still outstanding. Interest would have been $27,000,000 x 0.076 = $2,052,000 against the same $2,400,000 of operating profit, cover of just 1.17 times, and the lender's covenant required a minimum of 1.4.
The fictional company sold two of its weaker sites for $6,000,000 and repaid debt down to $21,000,000. Interest fell to $21,000,000 x 0.076 = $1,596,000 and operating profit dropped to $2,050,000 without those sites, so cover came out at $2,050,000 / $1,596,000 = 1.28 times, still short of the covenant and only fixed by a further equity injection from the owners.
Watch out
Common mistakes.
- Treating a low headline rate as a permanent condition and building a business plan that only works while it lasts.
- Comparing a project's return with the nominal interest rate while ignoring inflation and the real cost of the money.
- Borrowing short term at cheap rates to fund long term assets, which creates refinancing risk exactly when conditions turn.
Questions
People also ask.
What makes money cheap?
Low central bank policy rates, ample liquidity in the banking system and strong appetite among lenders, which together push borrowing costs down.
Can the real interest rate really be negative?
Yes, whenever inflation exceeds the nominal rate the borrower repays in money with less purchasing power than the money borrowed.
How should a business protect itself when money is cheap?
Fix rates for as long as sensibly possible, stagger maturity dates so everything does not refinance at once, and stress test the plan at a much higher interest rate.
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