Fleet Financing: Thinking of Converting to Fixed Rates?

Bob San­dler, Senior Vice Pres­i­dent, Cus­tomer Expe­ri­ence and Enter­prise Con­sult­ing, Ele­ment Fleet Man­age­ment

Inter­est rates have been low over the past few years. In fact, they have stayed low for so long that experts mon­i­tor­ing the state of the econ­o­my are pre­dict­ing an impend­ing increase in inter­est rates over the next few years. This has caused finance depart­ments to won­der if they should con­vert their assets to fixed inter­est rates in order to mit­i­gate the risk of poten­tial increas­es.

Here are four things to con­sid­er when mak­ing a deci­sion regard­ing fleet financ­ing and the move to fixed inter­est rates:

1. Experts may be wrong.
Once the inter­est rate is fixed, it will stay fixed until the asset is paid off. Since you pay a pre­mi­um to avoid the inter­est rate risk, your com­pa­ny will, at least for cer­tain length of time, pay more for fixed rate than it would for float­ing rate. For exam­ple, a com­pa­ny that three years ago would have elect­ed a fixed inter­est rate on 100 orders, each cost­ing $25,000, would have paid over $50,000 in extra inter­est on fleet assets over the past 36 months.

CXO Advi­so­ry has been track­ing and pub­lish­ing expert fore­casts of mar­ket direc­tion since 1998. Recent­ly, CXO pub­lished a review of over 6,000 fore­casts from all of the mar­ket “gurus” they tracked for 14 years. Over these 14 years, CXO con­clud­ed that the aver­age expert accu­ra­cy in call­ing the direc­tion of the mar­ket has been about 47%, or slight­ly worse than a coin toss.

2. Vehi­cles are paid off quick­ly.
Because of the quick pay-off term for most vehi­cles (36–60 months), inter­est rates would need to rise quick­ly to war­rant a fixed inter­est rate option. At the time of writ­ing, the dif­fer­ence between the float­ing rate (30-Day Libor @ 0.25%) and fixed rate (5-Yr Swaps @ 1.75%) is 1.50%. Float­ing rates would have to increase by more than that spread in a short time to jus­ti­fy the con­ver­sion to fixed rate financ­ing.

3. Pay­ing more on high­er book val­ue.
Book val­ue is the amount owed to the lessor. It decreas­es every month as you pay down the lease. Inter­est is always paid on the remain­ing book val­ue, so if your vehi­cle costs $20,000 and you pay $500 per month in prin­ci­pal, the inter­est rate of 2% in the first month will be applied to $20,000; in the sec­ond month, it will be applied to $19,500 and so on. If you elect a fixed inter­est rate, your orga­ni­za­tion will most like­ly be pay­ing a high­er inter­est rate in these begin­ning months when the book val­ue is at its high­est point. There­fore, if you stay on a float­ing rate and it increas­es to the same lev­el as the fixed rate with­in months or years, you would be incur­ring that high­er inter­est rate on low­er book val­ue.

4. Each unit may have a dif­fer­ent fixed rate.
A fleet con­sists of a large num­ber of assets. When using a fixed inter­est rate approach, only assets deliv­ered in the same month will have the same inter­est rate. Should the fixed inter­est rate increase the fol­low­ing month, new orders deliv­ered next month will have a high­er fixed inter­est rate. When look­ing at your port­fo­lio, your vehi­cles will have dif­fer­ent fixed inter­est rates that have increased or decreased with the mar­ket. There­fore, your port­fo­lio will float even when your inter­est rate for indi­vid­ual vehi­cles will be fixed. Since a fixed inter­est rate is almost always more expen­sive than a float­ing rate, you should care­ful­ly con­sid­er a deci­sion to elect fixed inter­est rates.

Obvi­ous­ly, the deci­sion regard­ing the inter­est rate depends on your orga­ni­za­tion and its tol­er­ance for risk. How­ev­er if you keep these four points in mind, mak­ing deci­sions when it comes to fleet financ­ing will be eas­i­er.

 

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