When the economy booms, it runs the risk of inflation. The Federal Reserve raises interest rates to combat inflation, 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. While it’s beneficial to the economy as a whole, you could end up paying higher interest rates over your small business loan, credit cards and lines of credit.
That may not seem likely given the current low interest rate environment brought on by the coronavirus pandemic. But with the economy growing and inflation rising, the Fed is reining in its pandemic bond-buying program sooner than previously planned. As a result, the market expected interest rates to increase in the first part of 2022.
What is the process for 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.
Generally, in an environment where the economy is booming and the Fed is trying to slow its growth, you’ll have to pay a higher interest rate than if the economy is stagnant or entering a recession.
Despite the coronavirus pandemic, the economy is booming and inflation is rising. That is a prime environment for the Federal Reserve to step in and raise interest rates.
What goes up when interest rates rise?
When interest rates increase, the percentage rates associated with lending programs also rise. Mortgages are the most notable financial product that increases after interest rates increase. Stock prices – like insurance stocks – are also likely to go up when interest rates rise.
Who benefits from rising interest rates?
Banks and brokerage firms benefit from rising interest rates, as do lenders and other businesses that make money on finance charges. Those who hold savings bonds and certificates of deposit also benefit from increased interest rates.
Don’t think rising interest rates matter to you and your company? Think again. When rates rise, the cost to borrow money and make purchases with credit cards increases. That has a direct impact on your cash flow.
How to prepare for rising interest rates
The Fed usually sends signals it is gearing up to raise interest rates so you won’t be caught off guard. If you are looking for small business financing, it’s important to act sooner rather than later. You want to secure your loan before interest rates tick up. You have fixed and variable interest rate options when it comes to funding your business.
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1. Consider fixed- and variable-rate loans.
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. When reviewing the best small business loans, we found many lenders offer fixed-rate loans with varying terms.
If rates look like they’re going to decrease, it’s better to get an adjustable-rate loan. This is a commonsense approach to adjustable and fixed interest rates, but other terms – 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 should 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% 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 for short-term loans. The details 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 entire duration of the loan term, then Espinosa’s short-term, rising rate advice holds true: Increased revenue should offset the increased rates. Accepting an adjustable rate in this scenario also gives you an opportunity to enjoy lower rates if they were to decrease down the line, Espinosa explained.
For example, if you are locked in for 25 or 30 years on an SBA small business loan 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 company’s financial situation. Espinosa said that deciding on a fixed-rate versus an adjustable-rate loan is most important for long-term property loans that span 25 to 30 years. In these scenarios, it’s vital to assess market conditions to make the right choice.
Consider why you are borrowing the money and for how long before you choose a loan type. If it’s a large sum that will take years to pay back, go with a fixed-rate small business loan.
2. Shop around for a better line of credit.
If interest rates rise next year, so will the APR on personal and business credit cards. Most credit cards charge prime plus a certain percentage. Interest rates increase as the prime rate rises. If you carry a balance on your company credit card, be mindful of this change; you may want to shop around for a better rate to save you money on interest charges.
Line of credits also increase in a rising interest rate environment. Many lines of credit are fixed. If yours isn’t, it may be time to refinance into one with a fixed interest rate. In our review of Fundbox, a top lender, we found it offers fixed-rate lines of credit with 12- to 24-week terms.
3. Refinance your debt.
Rising interest rates mean credit card and mortgage rates increase. An effective way to immediately save money is to refinance an expensive debt. That is particularly true if the debt is variable. Many small business lenders enable borrowers to use the loan proceeds to refinance expensive debt. If refinancing, consider keeping the length of the loan the same – or shorter – to avoid paying more interest in the end.
Which is better, fixed or adjustable rates?
The choice between a fixed- and adjustable-rate loan is not as simple as always opting for a fixed-rate loan, because rates are rising. It’s important to think about your own business’s situation. For example, it could be advantageous to take a fixed-rate loan on a property loan where you plan to stay for the full loan term. On the other hand, an adjustable rate 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, your increased revenue might offset the small-percentage rise in interest rates. As always, the right choice depends largely on your business’s financial situation.
Matt D’Angelo contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.