How to Prepare Your Business for Rising Interest Rates
July 16, 2018 | Last Updated on: April 3, 2023
July 16, 2018 | Last Updated on: April 3, 2023
What Rising Interest Rates Means for Your Business
The United States Federal Reserve has raised rates twice in the past eight months and signaled that more rate increases are on the way for 2018 and beyond. In many ways, the rate increases are a great thing, indicating that the economy is on the mend and doing well. In many other ways, the rate increases are cause for legitimate concern, because their effects can generate ripple effects in nearly every other part of the economy, particularly lending and loan interest rates.
When rates are low, people and businesses spend more, because their money is more valuable and powerful as a spending tool than an investment tool. As the economy grows, people tend to spend more, businesses invest in growth, and the price of credit grows as the demand increases. When rates rise, the increased cost of borrowing cools off the credit markets a bit and the money that was previously flowing into the economy tends to be held more in banks, as it’s more valuable as an investment.
The federal funds rate is the interest rate that banks use when lending money to each other. It helps set the high-water mark for nearly all other interest rates, and when the Fed raises rates most banks follow suit. The trickle-down effects from the rate increases show up in variable rate loans, credit cards, and other financial products, and can cause serious heartburn for business owners.
The cost of increasing interest rates can add up to thousands of dollars over the course of a loan, especially as they may rise even more in coming years. Existing borrowers that hold fixed-rate loans will not be impacted, but new borrowers and those with variable rate loans will feel the pinch.
Credit card holders, including those with business cards will see differences in their interest rates as well. Many cards will price their rates at “prime plus XX%”, and as the prime rate changes the interest rates will increase or fall accordingly. Business owners that pay their balances off each month will not have much to worry about, but the large number who do not will need to examine the increased costs involved with carrying a balance.
Similar to credit cards, lines of credit may be priced with an eye on the prime rate. Just like cards the impact can be great, perhaps more so with the larger balances that lines can carry. Banks may state in their agreement that rate changes happen at the lender’s discretion, or there may be a requirement to renew or sign a new loan agreement as the rate changes.
Commercial mortgage rates, while also increasing, may have other consequences beyond just the cost of interest. Many times, a loan will be acquired to build or improve a property with the intention of selling it quickly afterward, and as rates rise this can seriously undermine the owner or builder’s ability to find a buyer at a price they deem reasonable.
The effect of rising interest rates goes much further than loan prices. When rates are low, people and businesses tend to use their money instead of hiding it away in a bank. As the cash flows through the economy, many businesses see the need to invest in hiring to keep up with the demand from so many new consumers. The new employees go out and become consumers themselves, spending their newly-found paychecks, and the cycle continues from there. Increased demand for workers drives higher wages, and increased demand for “stuff” drives those prices. This effect is tied to inflation, which causes the Fed to raise rates in the first place, but as they do the cycle tends to slow.
As we already know, the cost of borrowing increases with the Fed’s rate. This has a cooling effect on all the spending and reinvesting and can lead many to hold their money in banks to generate the higher returns that come along with higher interest rates. Hiring may slow a bit, and overall spending follows suit. As our rates increase through 2018, we may start to see some of this slower movement creep in later in the year and through 2019.
While the rate increases can have a depressive effect on the economy and businesses’ ability to generate revenue, they play a necessary role in the country’s ability to grow and function properly. That sounds great on paper, but when a business owner starts to feel the heat from fewer customers and more expensive loan payments, the reality may seem much different. The good news is that the rate increases are usually not a huge surprise, that is to say that most of the time there are several warning signs that indicate that rates are working their way upward.
Business owners can take steps to ensure their operational health stays strong when things slow down a bit: