2.2.2 Term and Interest Rate Mode
Issuers must make decisions about the term of the debt (the period of time between issuance and the final payment) and the interest rate mode (a fixed interest through the term of the obligation or a variable rate, based on the market, tax law, and credit factors that may change over time). Although primarily driven by cash flow requirements and financial policies, the term and interest rate method may also be limited by the state laws authorizing the debt issuance or by federal tax law considerations. See Chapter 3, Types of Debt Obligations Issued by Public Agencies and Chapter 4, Federal and State Tax Law Requirements.
With regard to term of the debt, public agencies apply a second general operating principle:
Second General Operating Principle of Municipal Debt—Financed facilities should be paid for over a substantial portion of the useful life of the facilities (intergenerational equity).62
Municipal debt obligations are generally structured to be payable over a term corresponding to the purpose for which the debt is incurred. Long term debt is used to finance capital items with long useful lives and short term debt is used to finance capital items with short lives or for cash flow management. Long term assets are, however, occasionally financed on an interim basis, with the expectation of securing and committing to provide “long term, take out financing.”63 Matching the term of the debt to the useful life of the asset does not necessarily imply a chronological matching. For example, the useful life of many public buildings is 50 years or more, while the debt issued to finance the construction of the building is usually 30 years.
The choice of whether to use a fixed rate or variable rate approach may be more difficult to make. Except under highly unusual market conditions, short term interest rates are lower than long term rates. Although variable rate and interim financing can increase flexibility and reduce borrowing costs they come with significant additional risks, are difficult to forecast, and do not mesh well or at all with some sources of payment and security. This makes them impractical alternatives for many local government borrowers.