When the economy booms, it runs the risk of inflation. To combat inflation, the Federal Reserve raises interest rates, thereby making money more expensive to borrow and discouraging cash flow throughout the economy. This fight against inflation is what causes the rising rate environment, and while it's beneficial to the economy as a whole, you could end up paying higher interest rates over time on an adjustable-rate loan.
"We're coming off a period of the lowest interest rates we've had in what, 40 or 50 years?" said Mark Cussen, a financial expert who regularly contributes to the online financial news and education website Investopedia. "The economy has been growing at a great clip and unemployment is low, so they're wanting to just tamper the growth a little bit and slow it down by raising rates."
The Federal Reserve controls the federal funds rate, which is the interest rate that banking institutions charge each other to lend money. This adjustment has a ripple effect on other interest rates, like the ones banks use to provide loans to small businesses. Banks often provide a rate indexed by market conditions and then add a margin on top of that rate.
The overall process from the Fed raising the federal funds rate to you being charged a higher adjustable interest rate is complex, but know that in an environment where the economy is booming and the Fed is trying to slow growth, you'll have to pay a higher interest rate than if the economy is stagnant or entering a recession.
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Fixed- and adjustable-rate loans in a rising rate environment
Cussen said that if you're applying for a loan when interest rates are starting to rise, it's almost always better to get a fixed interest loan. This means that as interest rates rise, you'll be making the same payments each month – so you'll be able to predict how much your loan costs throughout the life of your loan.
"I would see no reason to take an adjustable-rate loan right now," Cussen said. "Interest rates are only going to go up from here."
If rates look like they're going to decrease, it's better to get an adjustable-rate loan. This is a common-sense approach to adjustable and fixed interest rates, but other things, like the length of your loan, can be important factors in your decision.
Alex Espinosa, who specializes in SBA loan consulting and runs BOLD Lender, said that a fixed-rate loan in a rising rate environment may not always be the best choice for your business. Rising rate environments are the sign of great economic times, so while the interest rate on your loan may be rising, so will (hopefully) your sales and overall revenue.
"It gives businesses a chance to plan for the future – how they have to adjust," Espinosa said. "If their sales are going up 20 percent in a couple years and their interest rate rises a couple percent, who cares? They're still coming out ahead."
If this is the case, then an adjustable rate may be worth considering on short-term loans. Things get a bit more complicated on longer-term loans. If you're taking out a long-term loan on a piece of property, for example, but don't plan on staying for the full duration of the loan term, then Espinosa's short-term rising rate advice holds true – increased revenue should offset the increased rates. Taking an adjustable rate in this scenario also opens the opportunity to enjoy lower rates if they were to decrease down the line, according to Espinosa.
If you're locked in for 25 or 30 years and have no desire to sell your property before the end of the term, it's likely better to choose a fixed-rate loan in a rising rate environment. This will vary, of course, based on your business's specific situation. Espinosa said that the decision on a fixed- vs. adjustable-rate loan is most important for long-term property loans that span 25 to 30 years. In these scenarios, it's important to assess market conditions and make the right choice.
The choice between a fixed- and adjustable-rate loan is not as simple as opting for a fixed-rate loan because rates are rising. Both Espinosa and Cussen said it's important to think about your own business's situation. It could be advantageous to take a fixed-rate loan on a long-term property loan where you plan to stay for the full loan term, for example. An adjustable rate, on the other hand, may be better in short-term situations.
The most important takeaway is that, while this may seem like a big decision, if you're working with short loan terms – just a few years, for example – your choice may not have the impact you expect. If you choose an adjustable-rate loan in a rising rate environment but your term is only a few years, there's a possibility that your increased revenue will offset the small-percentage rise in interest rates. As always, however, the right choice depends largely on your business's situation.