The High Cost of Low Interest Rates

MANAGEMENT

Even when interest rates are at historic lows, interest costs can be significant for businesses and owner-managers.

The Business

The significant rise in the cost of equipment, vehicles, real estate, and inventory has prompted many businesses to increase business debt. Low interest rates, combined with the ability to obtain larger loans with extended payment terms, have allowed businesses to operate in a “business as usual” mode with less consideration for the actual cost of borrowing.

To give some idea of the effect of even low interest rates on an owner-managed business, the following key elements of most businesses have been put forward as an example of the effect of interest costs on a business. The effect of domestic borrowing has been added to show the full impact of current interest rates on the owner-manager. Since lending rates vary widely depending on a variety of factors such as risk, item to be funded and the term, and are usually negotiated, the interest rates used below have been chosen at random from Internet sources; calculations are approximate and for illustrative purposes only. All loans have been made effective June 1, 2017.

• Commercial mortgage: $600,000 over 25 years at 3%
• Two work vehicles: $120,000 financed over five years at 6%
• Equipment loan: $200,000 financed over five years at 5%
• Operating line of credit: $50,000 at 3% a year
• Credit card debt: $10,000 at 15% a year on the outstanding balance

Commercial Mortgage

• Commercial mortgage amount: $600,000
• Interest for first year: $17,776
• Interest paid over first five years: $83,748
• Interest paid over the 25 years (300 months) of payment: $253,580
• Total commercial mortgage cost: $853,580

A sobering reality is that, when interest costs are factored in, the $600,000 building ends up costing $853,580. Assuming the interest is a deductible business expense, and assuming a 17% corporate tax rate, total interest would be reduced by $43,109, thus reducing the overall cost of purchasing to $810,471.

Work Vehicles

• Total purchase price of two vehicles: $120,000
• Interest for first year: $6,623
• Interest for five years: $19,196
• Total vehicle cost: $139,196

Equipment Loan

• Loan amount: $200,000
• Interest for first year: $9,179
• Interest for five years: $26,455
• Total loan cost: $226,455

Line of Credit

• Annual outstanding balance: $50,000
• Interest for one year: $1,500
• Interest for five years: $7,500

Credit Cards

• Average annual outstanding balance: $10,000
• Interest for one year: $1,500
• Interest for five years: $7,500

Over five years, the total interest cost to your business is $144,399. Even at a 17% corporate tax rate and a corresponding $24,548 reduction over five years, the cost of borrowing is still $119,851.

The hard truth is that interest costs even in times of low interest rates have a very negative impact on the bottom line.

Canadians are extending repayment periods.

On the Home Front

At the end of Q1 of 2017, the ratio of Canadian household debt to disposable income was 1.67:1 or $1.67 of debt for every $1 of disposable income. Canadians borrowed $27.5 million in the first quarter, of which mortgages accounted for $20.9 billion. Not only are Canadians borrowing a lot of money, they are extending the periods of repayment for some expensive items. Recent statistics indicate that in excess of 40% of all new vehicles purchased are financed from 61 to 72 months; loans extending from 73 to 84 months now make up almost 20% of new vehicle loans.

Home equity lines of credit (HELOCs) have increased as well. There are currently about three million HELOC accounts in Canada; the average outstanding balance in each account is estimated at $70,000.
For a moment, consider that the owner-manager, in addition to the business debt that has to be serviced, has the following personal debt with the same interest rates as the business.

Residential Mortgage

• Mortgage: $400,000 amortized over 25 years at 3%
• Interest for first year: $11,851
• Interest paid over five years: $55,833
• Interest paid over 25 years (300 months): $169,054
• Total mortgage cost over 25 years: $569,054

Vehicle Loans

• Two vehicles: $80,000 financed over five years at 2.7%
• Interest for first year: $1,974
• Interest for five years: $5,611
• Total vehicle cost: $85,611

HELOC

• Average annual outstanding balance: $70,000 for five years at 3.2%
• Interest for first year: $2,240
• Interest for five years: $11,200
• Total loan cost: $81,200

Total interest cost to service personal debt for five years is $72,644.

Given that the interest costs are in after-tax dollars and assuming the individual is in a 30% tax bracket, the taxpayer has effectively paid an additional $20,186 as well as the opportunity costs of not being able to purchase investments or other consumer goods.

Impact on Business

Interest costs affect owner-managers both at business and home. Business interest costs dictate the need to increase cash flow to service the debt and therefore drive the need to increase sales volumes or prices to maintain a sustainable profit.

Maintaining a lifestyle supported by debt increases the need to earn more money to service that debt. For the owner-manager, that means procuring a higher income from the business. This, in turn, creates additional pressure on the business to increase cash flow, sales volumes, or prices to satisfy the owner’s personal needs. An added consternation is personal income tax. Not only will the additional income to the owner-manager create a higher personal income tax, but it may result in increased business expenses for other source deductions.

Risks of Low Interest Costs

The cost of borrowing, whether for business or for personal needs, has a significant impact on the owner-manager as well as on business operations. The service costs of debt are a major drag on cash flow, profits, and the future financial health of the business, even in periods of historically low rates such as we are living in right now. But merely making the monthly payments is not enough; the loan must eventually be repaid. With interest rates so low and the cost of borrowing so high, there is a serious risk that, when the bank rate starts to move up again, as it inevitably will, many owner-managers will be caught offside and unable to make even the monthly payments.

Don’t let that owner-manager be you.