Overview
Fixed vs floating rate clauses in commercial loan agreements define how interest is calculated and reset over the life of a loan. A fixed clause locks the borrower into a fixed interest rate for a defined period or the entire loan term. A floating clause ties the loan’s rate to an external benchmark plus a spread, allowing the rate to move with market conditions.
These choices affect cash flow volatility, budgeting accuracy, and the cost of capital. In my 15 years advising businesses, I’ve seen companies lose flexibility or take on unexpected interest expenses because the loan’s rate mechanics weren’t fully vetted at signing. This guide explains how these clauses work today (including post-LIBOR benchmark practices), key contract terms to negotiate, practical strategies, and realistic examples you can use when reviewing or negotiating a commercial loan.
Sources: CFPB, Federal Reserve, and market transition guidance on benchmarks (e.g., SOFR).
How fixed rate clauses work
A fixed rate clause specifies an interest rate that does not change for the fixed period stated in the loan agreement. Typical features:
- A clearly stated nominal rate (for example, 5.00% per annum).
- Payment schedule and amortization tied to that rate.
- May include a fixed-rate conversion option, prepayment penalties, or breakage costs if the borrower pays off or refinances early.
Advantages:
- Predictable interest expense aids budgeting and cash-flow forecast accuracy.
- Easier to get internal approvals and covenant compliance because interest costs are stable.
Drawbacks:
- Borrowers lock in the market price at signing. If market rates fall, the borrower keeps paying the higher fixed rate.
- Fixed rates can include a premium compared with initial floating offers, reflecting the lender’s risk of future rate increases.
Business example: A manufacturing company takes a 10-year commercial mortgage at a fixed 4.5% rate. The company can forecast debt service reliably, which simplifies product pricing and working capital planning.
Useful internal resource: see our guide on Fixed Rate Conversion Option for ways borrowers may limit the downside of a fixed rate.
How floating rate clauses work (benchmarks, spread, and reset)
A floating (variable) rate clause ties the loan’s interest rate to a market benchmark plus a lender margin (spread). Common elements include:
- Benchmark: historically LIBOR, but the market has moved to SOFR (Secured Overnight Financing Rate) and other reference rates; most new U.S. commercial loans reference SOFR, the prime rate, or a bank’s base rate (see Federal Reserve and industry transition guidance).
- Spread / Margin: the lender’s add-on, e.g., SOFR + 250 bps (2.50%).
- Reset frequency: daily, monthly, quarterly, or tied to payment dates.
- Lookback and observation period: some contracts use a lookback (e.g., 5 days) when setting the new rate.
- Floors and caps: agreements can include a minimum rate (floor) or maximum adjustment (cap).
Advantages:
- Initial borrowing cost often lower if markets expect stable or falling rates.
- Borrowers benefit directly when benchmark rates fall.
Drawbacks:
- Cash-flow variability: rising benchmarks increase payments and can stress liquidity.
- Planning complexity: budgeting must include rate stress scenarios.
See our primer on What is a Floating Interest Rate? for definitions and examples used across loan types.
Benchmark transition: LIBOR to SOFR (important contract detail)
LIBOR has been phased out as the primary U.S. dollar benchmark for most new business loans. Lenders now commonly use SOFR or term SOFR, along with fallback language, to address past LIBOR-linked contracts. When reviewing floating clauses today, confirm:
- Which benchmark is named (SOFR, prime, or bank’s base rate).
- Whether the loan includes fallback language to replace a discontinued benchmark.
- How any historical LIBOR references are adjusted (e.g., spread adjustments to account for differences between LIBOR and SOFR).
Resources: Federal Reserve and the Alternative Reference Rates Committee (ARRC) have published transition guides and recommended fallback language, which lenders and borrowers should follow to reduce legal and valuation risk.
Key contract terms to negotiate
When reviewing or negotiating a clause, focus on these items:
- Benchmark definition and fallback mechanics (essential post-LIBOR).
- Spread/margin and repricing schedule.
- Reset frequency and lookback period.
- Interest rate floor or cap and whether the borrower pays into a cap cost.
- Prepayment/early termination provisions and breakage clauses (especially for fixed rates).
- Conversion or call options allowing the borrower to switch between fixed and floating (see Fixed Rate Conversion Option).
- Hedging permissions and representations: does the agreement allow you to enter interest rate swaps or caps?
- Covenant triggers tied to interest coverage ratios and how rate changes affect them.
Negotiation tip from practice: Always ask for borrower protections around the benchmark and clear fallback rules. In syndications, mismatched fallback language across lenders can create re-pricing shocks.
Hedging and risk-management tools
To control floating-rate exposure, businesses use derivative tools:
- Interest rate swaps: exchange floating-rate payments for fixed-rate payments.
- Interest rate caps and collars: limit the maximum (cap) or both minimum and maximum (collar) floating payments.
- Forward rate agreements: lock a future floating rate for a given period.
Hedging comes with costs and accounting implications. For many commercial borrowers, a partial hedge or a cap on a percentage of the principal balances cost-effectively balances risk and price. See our related guide on Interest Rate Hedging for Mortgages for basic hedging concepts that apply to commercial loans as well.
Practical examples and stress tests
Example 1 — Floating loan stress test:
- Loan: $1,000,000, floating rate = SOFR + 2.00%.
- Initial SOFR: 0.50% → initial rate = 2.50% → annual interest = $25,000.
- Rate shock: SOFR rises to 3.50% → new rate = 5.50% → annual interest = $55,000.
Result: Interest expense more than doubles. If cash flow is tight, this shock can violate covenants or force operational cuts.
Example 2 — Fixed vs floating decision:
- Borrower A locks a fixed 5.0% rate for 5 years.
- Borrower B chooses floating at SOFR + 1.50% when SOFR = 0.75% (total 2.25%). If SOFR averages 1.25% over five years, Borrower B pays 2.75% on average and saves vs. fixed. If SOFR averages 4.0%, Borrower B pays 5.50% and loses.
These examples underline the importance of scenario planning. Build a 3-point plan: base, upside (rates fall), downside (rates rise) to see contingencies.
Who is affected and eligibility considerations
Most commercial borrowers—small businesses, real estate investors, middle market companies—face this choice. Considerations:
- Cash flow stability: stable cash flows favor fixed rates.
- Growth expectations: businesses expecting rising margins may accept floating risk.
- Access to markets: larger borrowers can often negotiate better spreads or obtain hedges at lower cost.
- Loan purpose: short-term bridge financing may favor floating rates for flexibility.
If you’re unsure which path fits your business, consult a lender and a financial advisor for modeling and covenant stress testing.
Common mistakes to avoid
- Leaving benchmark fallback language vague (a major risk since LIBOR’s phaseout).
- Ignoring lookback and reset mechanics — small drafting points can create large cash-flow timing mismatches.
- Assuming conversion from floating to fixed is free — there are often fees or market-based breakage costs.
- Failing to model covenant effects under rising-rate scenarios.
FAQs (concise answers)
- Can a floating rate loan be converted to fixed? Often, yes — but it depends on the loan’s conversion option and may involve cost. Consider negotiated conversion windows or documented conversion formulas.
- Are floating rates always cheaper? No. Floating rates can start lower but may become more expensive over time, especially in a rising-rate cycle.
- What benchmarks are now standard? SOFR is the primary U.S. benchmark replacing LIBOR for many loan types; prime and bank base rates are still common (Federal Reserve guidance and ARRC resources provide details).
Negotiation checklist (actionable)
- Confirm the benchmark and inspect fallback language.
- Request the spread and ask how it compares to market comps.
- Verify reset frequency, lookback, and day-count conventions.
- Ask for a capped rate or conversion option.
- Run covenant stress tests at +200 bps and +400 bps scenarios.
- If hedging, confirm derivative permissions and accounting treatment.
Final thoughts and professional disclaimer
Selecting between fixed vs floating rate clauses is a strategic decision tied to risk tolerance, cash-flow predictability, and market views. In my experience advising clients, the best outcomes come from clearly drafted loan language, robust scenario modeling, and having at least one contingency (a conversion option, cap, or hedge) if markets move against you.
This article is educational and does not constitute personalized financial or legal advice. Consult your lender, a licensed financial advisor, and your attorney for decisions about specific loan documents and taxes. Authoritative sources consulted include the Consumer Financial Protection Bureau and the Federal Reserve’s guidance on benchmarks and market practices.
References and further reading
- Consumer Financial Protection Bureau: https://www.consumerfinance.gov
- Federal Reserve: https://www.federalreserve.gov
- For practical borrower options: Fixed Rate Conversion Option, What is a Floating Interest Rate?, Interest Rate Hedging for Mortgages.
