How Does the Interest Rate Affect Financial Leverage?
Interest rates have a big effect on how much a business or individual can borrow. People or companies that borrow money are said to be leveraged. Lower interest rates mean they can afford to borrow more money, which can get them in over their heads.
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Financial Leverage
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Financial leverage is basically a fancy term for debt. When a person takes on debt such as a mortgage, or a company issues debt in the form of bonds, they are leveraged. That means they are operating on cash that belongs to someone else, and to whom they owe interest payments.
Interest Rates
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Central banks such as the U.S. Federal Reserve establish interest rates. The Federal Open Market Committee meets eight times a year to determine appropriate interest rates. They lower rates to stimulate the economy and raise them to slow things down. Banks follow the rates set by the Fed in determining what interest percentage to charge their customers.
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Low Rates Stimulate
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When interest rates are down, businesses can borrow money at a low cost of capital. For instance, a company that borrows $10 million at a low 3 percent rate has to pay $300,000 a year in interest, while a company borrowing the same amount at a high 9 percent rate pays $900,000 a year. The first company can therefore borrow three times as much money at the same interest cost. If they're not careful this can lead to excessive borrowing, or leverage, that can get them in over their heads.
When Leverage Kills
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Companies that have borrowed too much money can get into real trouble if the economy turns south or their lenders require them to refinance at a higher interest rate. If revenues slow amid a weak economy, these companies can struggle to have enough cash flow to make their debt payments. This can lead to bankruptcy.
Real-Life Case
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The above is exactly what happened at the end of the 2000 decade. The Federal Reserve allowed interest rates to stay too low for too long earlier in the decade, leading to a borrowing binge on the part of both individuals and companies. When interest rates rose and the economy slowed in 2007, many of the companies and individuals that took on too much leverage faced ruin in the form of home foreclosures, personal bankruptcy, declining stock prices and government bailouts.
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