To comply with Governmental Accounting Standards Board (GASB) Statement No. 87 “Leases” (GASB-87), you’ll likely be required to determine your organization’s incremental borrowing rate (IBR) for at least one of your leases.
The goal of this article is to provide an overview of two key items:
- The incremental borrowing rate
- DebtBook’s approach to calculating the incremental borrowing rate
Let’s get started.
What is the Incremental Borrowing Rate?
Basically, the incremental borrowing rate (IBR) is an estimate of the theoretical interest rate you would have been charged had you financed the acquisition of a particular asset rather than leasing it. For example, if you leased a piece of equipment over 5 years, your incremental borrowing rate would be the interest rate you would have paid on the loan had you decided, instead, to take out a 5-year loan to buy the equipment up front.
How would you calculate your incremental borrowing rate?
You could ask a bank to provide you with a rate each time you enter into a new lease, but that may quickly become burdensome for both you and the bank. Rather than asking directly each time, you could use a simple framework to estimate the rate a bank would have charged.
While every bank has its own formula and approach to loan pricing, generally speaking, your interest rate is equal to the bank’s cost of funds plus a premium (or credit spread) to account for the bank’s perceived risk in making the loan to you. You can summarize this approach with this simple formula:
(Bank’s Cost of Funds) + (Credit Spread) = Interest Rate
The bank’s cost of funds reflects its underlying cost when making the loan. It essentially amounts to the bank’s “break even” rate and is generally tied to the broader interest rate environment.
The credit spread reflects the amount the bank charges in addition to its cost of funds to generate return that corresponds to its perceived risk in making the loan. This value fluctuates up and down based upon various credit, liquidity, and other market-based factors.
If you decide to reach out to your banker to ask for the bank’s cost of funds and credit spread for a particular loan – or simply to ask for the final rate the bank would charge – your banker will need some basic information in order to provide you with a reasonable answer:
- The term of the loan (matching the term of the lease)
- The start date of the loan (matching the start date of the lease)
- The security for the loan
- The tax status of the loan (e.g., whether the asset would be eligible for tax-exempt financing)
Just note that getting a new rate for each lease will require you to go back to your banker time and time again. That plan may work perfectly well for you – if so, you may not need to continue reading – but as an alternative, we wanted to provide a simple framework that you can use (along with your auditor) to estimate your incremental borrowing rate quickly and easily.
DebtBook’s Approach to the Incremental Borrowing Rate
For those who don’t want to go to your banker for a separate rate every time you enter into a new lease, we wanted to build a simple yet powerful template to estimate your incremental borrowing rate.
As you read ahead, there are a couple thing to keep in mind:
- We are not trying to calculate the exact rate you would have been charged. The goal of the exercise is to have a reasonable basis for developing an accurate estimate of what your interest rate would have been.
- Instead of assuming each loan would be secured by the underlying asset (which would require you to calculate multiple incremental borrowing rates across multiple asset classes), we assume you would use your lowest interest rate financing vehicle (typically a general obligation or general revenue bond) to purchase the asset. This approach simplifies the process and reduces the information you need to gather. For more details on this assumption, click here.
- We want the framework for calculating your incremental borrowing rate to be simple, practical, and repeatable, as you’ll need to recalculate your incremental borrowing rate periodically moving forward.
With these basic assumptions, DebtBook has created a simple Excel template to calculate your incremental borrowing rate using the same interest rate formula outlined above:
(Bank’s Cost of Funds) + (Credit Spread) = Incremental Borrowing Rate
We assume the bank’s cost of funds will match the United States Treasury Yield Curve, which is the most commonly quoted and readily available index for determining cost of funds. Note this isn’t perfect, as each bank may use different indices or a combination of indices and other factors to calculate their own subjective cost of funds, but we believe the United States Treasury Yield Curve provides a reasonable proxy across a wide variety of circumstances and markets.
DebtBook then asked several commercial banks to provide generic credit spreads above the applicable US Treasury yield that they would reasonably expect to charge public sector borrowers based on their rating category and the term of the loan. We averaged the responses to come up with our own generic credit spreads used in the template. We will periodically update the template’s credit spreads, if necessary, but remember our goal is to provide a reasonable basis for estimating your incremental borrowing rate, not to derive the exact rate for each and every lease.
Here’s an example. If your “AA”-rated municipality entered into a lease commencing on September 1, 2020 for a term of 36 months, we would use the three-year United States Treasury Rate as of September 1, 2020 to estimate your cost of funds and then add the average credit spread provided to us for a 36-month, AA-rated loan.
So, if the three-year US Treasury on September 1, 2020 was 0.14% and the average credit spread for a three-year, AA-rated loan was 1.10%, then we can estimate your incremental borrowing rate to be 1.24% using the simple formula below:
0.14%+ 1.10% = 1.24%
Note the calculation above assumes a taxable financing. In our template, you can make simple adjustments to account for a lower tax-exempt rate, if appropriate for your circumstances.
DebtBook makes powerful debt and lease management software for governments and nonprofits. You spend less time finding and fixing spreadsheets, more time leading your team forward with confidence.