Fixed vs Variable Interest Rates

A fixed interest rate remains constant for the entire term of the loan or for a defined lock period within the loan agreement. The rate is set at origination based on prevailing market conditions, the borrower's credit profile, and the lender's cost of funds. Once locked, the borrower's periodic payment amount does not change regardless of shifts in broader interest rate markets.

In commercial lending, fixed rates are commonly found on term loans with maturities of 3 to 10 years, SBA 504 loans (the CDC portion), and many Commercial Real Estate loans structured with balloon payments. The fixed rate gives borrowers certainty in debt service planning, which is particularly valuable for businesses with predictable cash flows or thin operating margins where even small payment fluctuations could create stress.

Lenders price fixed rates by referencing benchmark yields, typically U.S. Treasury securities of comparable maturity, and adding a spread that reflects credit risk, collateral quality, and competitive positioning. A 7-year fixed commercial loan, for example, might be priced as the 7-year Treasury yield plus 250 to 400 basis points. Because the lender is assuming interest rate risk for the full term, fixed rates are generally higher than the initial rate on a comparable variable-rate loan.

It is important to understand that "fixed" does not always mean fixed for the full amortization period. Many commercial loans carry a fixed rate for 5 or 7 years but amortize over 20 or 25 years, resulting in a balloon payment at maturity. The borrower then refinances at whatever rates prevail at that point. This distinction between rate term and amortization term is critical when evaluating the true cost profile of a fixed-rate structure.

A variable interest rate (also called a floating rate or adjustable rate) changes periodically based on movements in a reference index. The borrower's rate is calculated as the index value plus a fixed margin, sometimes called a spread. For example, a loan priced at SOFR plus 300 basis points would carry a rate of 8.30% if SOFR sits at 5.30% on the adjustment date.

The most common reference indexes in U.S. commercial lending include:

• SOFR (Secured Overnight Financing Rate) - the primary replacement for LIBOR, based on overnight Treasury repurchase agreement transactions
• Prime Rate - the base rate published by major banks, typically 300 basis points above the federal funds rate
• U.S. Treasury yields - used less frequently for variable structures but common as fixed-rate benchmarks

The adjustment period determines how often the rate resets. Common intervals are monthly, quarterly, or annually. A loan that adjusts monthly will track the index more closely, meaning payments can change every 30 days. Annual adjustments provide more short-term stability but can produce larger single-step changes.

Many variable-rate commercial loans include rate caps to limit borrower exposure. A periodic cap restricts how much the rate can move in a single adjustment (for example, no more than 200 basis points per year). A lifetime cap sets an absolute ceiling on the rate for the entire loan term. Floor provisions, conversely, set a minimum rate the lender will accept regardless of how low the index drops. These caps and floors create a defined range within which the rate can move.

The margin portion of a variable rate is negotiated at origination and typically remains constant for the life of the loan. Borrowers with stronger credit profiles, more collateral, or larger loan amounts generally secure tighter margins. The margin is where the lender's profit and risk premium live, and it is the primary lever a borrower can influence through negotiation and competitive bidding.

The choice between fixed and variable rates is fundamentally a question about total cost of capital over the life of the loan, not just the rate at origination. A variable rate that starts 150 basis points below a comparable fixed rate can end up costing significantly more if indexes rise substantially during the loan term. Conversely, a fixed rate locks in a higher cost from day one that may prove expensive if market rates decline or remain flat.

To illustrate the math: on a $1 million commercial loan over 7 years, the difference between a 7.5% fixed rate and a variable rate that averages 7.0% over the same period represents roughly $35,000 in total interest savings for the variable structure. But if that variable rate averages 8.5% instead, the fixed-rate borrower saves approximately $70,000. These swings are meaningful for mid-market businesses where debt service is a significant line item.

Several factors influence which structure produces lower total cost:

• Rate environment trajectory - In a declining or stable rate environment, variable rates tend to produce lower total cost. In a rising rate environment, fixed rates protect against escalating payments.
• Loan duration - Shorter loan terms reduce variable-rate risk because there is less time for rates to move against the borrower. On a 2-year bridge loan, the variable-rate discount at origination usually outweighs potential upward movement.
• Prepayment flexibility - Variable-rate loans typically carry lower or no prepayment penalties, which can reduce effective cost if the borrower refinances or pays off early.

Sophisticated borrowers model multiple scenarios: rates flat, rates up 200 basis points, rates down 100 basis points. The total cost difference across these scenarios defines the borrower's interest rate exposure and informs the fixed-vs-variable decision.

Different commercial loan products default to different rate structures, and understanding these patterns helps borrowers anticipate what lenders will offer before entering negotiations.

Typically fixed-rate products:

• SBA 504 loans (CDC portion) - The debenture funded through the Certified Development Company carries a fixed rate tied to Treasury bond yields at the time of the monthly debenture sale.
• Commercial mortgage-backed securities (CMBS) - These loans are packaged and sold to investors who expect predictable cash flows, so they almost always carry fixed rates with strict prepayment provisions.
• Equipment financing - Most equipment loans and leases use fixed rates because the asset's useful life and depreciation schedule are known quantities.

Typically variable-rate products:

• Business lines of credit - Almost universally variable, priced off Prime or SOFR. The revolving nature of the facility makes fixed pricing impractical.
• SBA 7(a) loans - The majority carry variable rates tied to Prime, adjusting quarterly. Fixed-rate SBA 7(a) loans exist but are less common and limited to shorter maturities.
• Working capital loans - Short-term facilities that typically float with Prime or a similar index.
• Bridge loans - Short-duration loans designed for transitional situations, almost always variable.

Products where both structures are common:

• Commercial real estate loans - Banks offer both fixed and variable options depending on property type, loan size, and borrower preference. Multifamily loans through agency programs (Fannie Mae, Freddie Mac) frequently offer both.
• Commercial term loans - Available in either structure depending on the lender and borrower profile. Banks may offer fixed rates on shorter terms (3-5 years) and variable on longer terms.

A rate lock is a commitment from a lender to honor a specific interest rate for a defined period while the loan moves through underwriting and closing. Rate locks protect borrowers from market movements during the often lengthy commercial loan origination process, which can take 30 to 90 days or longer for complex transactions.

Rate locks in commercial lending work differently than in residential mortgages. Key mechanical differences include:

• Lock periods - Commercial rate locks typically range from 30 to 60 days, though some lenders offer extensions for an additional fee. SBA and CMBS programs have their own lock timing tied to pool settlement dates.
• Lock deposits - Many commercial lenders require a deposit (often 0.5% to 1.0% of the loan amount) to secure a rate lock. This deposit may be refundable if the lender fails to close, but non-refundable if the borrower withdraws.
• Rate lock fees - Some lenders charge an explicit fee for locking, separate from the deposit. This fee compensates the lender for hedging the interest rate risk during the lock period.
• Float-down provisions - A float-down allows the borrower to benefit from rate decreases after locking. These provisions are negotiable but typically come with conditions, such as a minimum rate decrease threshold before the float-down activates.

The strategic decision of when to lock depends on the borrower's view of rate direction and risk tolerance. Locking early provides certainty but forfeits potential savings if rates decline before closing. Floating until close preserves optionality but exposes the borrower to upward rate movements that could materially change deal economics. For transactions where debt service coverage is tight, locking early is generally the prudent choice because even a modest rate increase could push the deal below the lender's minimum coverage threshold.

Borrowers should also understand that a rate lock is specific to the loan terms agreed upon. Material changes to the loan amount, property value, or borrower financials during the lock period can void the lock and require re-pricing.

Not every commercial loan fits neatly into a fixed or variable category. Hybrid structures combine elements of both, giving borrowers a middle path between payment certainty and rate flexibility.

The most common hybrid structure is the fixed-to-variable loan, where the rate is fixed for an initial period (commonly 3, 5, or 7 years) and then converts to a variable rate for the remaining term. These are often described using shorthand like "5/1 ARM" (fixed for 5 years, adjusting annually thereafter). The initial fixed period gives the borrower predictable payments during the early years when cash flow stabilization is most critical, while the variable tail often carries a lower blended cost than a fully fixed loan of the same total term.

Another hybrid approach involves interest rate swaps, which are derivative contracts that effectively convert a variable-rate loan into a fixed-rate obligation. The borrower enters into a swap agreement with a bank (often the same lender) in which the borrower pays a fixed rate and receives a floating rate that offsets the variable interest on the loan. The net effect is a synthetically fixed rate. Swaps are common on larger commercial loans ($3 million and above) and offer several advantages:

• The underlying loan retains the prepayment flexibility of a variable-rate facility
• The swap can be structured for a shorter period than the loan term, giving the borrower fixed-rate protection only during the period of greatest exposure
• Swap rates are often more competitive than equivalent fixed-rate loan pricing because the lender retains less balance sheet risk

Interest rate caps are another hedging tool. A borrower with a variable-rate loan can purchase a cap contract that pays the borrower the difference whenever the reference rate exceeds a specified strike rate. This effectively creates a ceiling on borrowing costs while preserving the benefit of lower rates. Caps require an upfront premium, which varies based on the strike rate, term, and market volatility. Some lenders require borrowers to purchase rate caps as a condition of variable-rate loan approval, particularly on higher-leverage transactions where rate increases could impair debt service coverage.

The choice between a pure fixed, pure variable, or hybrid structure should align with the borrower's business plan timeline, refinancing expectations, and tolerance for payment variability. A borrower planning to sell a property in 3 years has different needs than one holding for 15 years, and the rate structure should reflect that difference.