Understand Variable Interest Rates as a Small Business Owner
July 20, 2022 | Last Updated on: February 3, 2023
July 20, 2022 | Last Updated on: February 3, 2023
In this article, we cover:
Small business owners can leverage a wide range of financing options to raise capital to help them expand, tap into a line of credit when needed, purchase equipment, purchase inventory, hire or retain talent, acquire another business, and more. That capital comes at a cost in the form of interest payments on top of paying back the principal of the loan. Variable interest rates can be an attractive option depending on your situation, but pitfalls also exist. Business loan interest rates change frequently based on the macroeconomic environment.
When taking out a loan for your small business, understanding the business loan interest rate is critical because it directly impacts your repayment amount. Interest on a loan payment is the fee for borrowing money. When you borrow money from a lender, you don’t just pay back the principal, but the principal plus interest.
There are two types of interest rates we are focused on in this article: fixed and variable.
As their names suggest, a fixed rate remains the same for the lifetime of the loan while a variable rate adjusts at certain intervals based on an underlying benchmark interest rate or index.
There are many types of small business loans depending on your business needs, and the underlying benchmark interest rate or index for a variable interest rate depends on the type of loan, the size of the loan, the time it takes to repay the loan, etc. It is often associated with the London Inter-Bank Offered Rate (LIBOR) or the federal funds rate. When working with online lenders, note what your variable interest rate loan is tied to during the loan application process.
When taking out a loan for your small business, consider the following pros and cons of variable interest rates:
Suppose a small business owner is considering taking out a 7(A) loan from the U.S. Small Business Administration (SBA). When looking to secure an SBA loan, let’s say an SBA 7(a) loan from a small business lender, you might be offered a loan within the following interest rate range depending on your credit history, personal finance, the size, and duration of the loan repayment:
Note the ranges of the variable rates vs fixed rates. As noted above, you will likely start with a much lower interest rate with a variable rate loan.
The SBA established interest-rate guidelines for lenders for their loan programs to keep small-business borrowing costs as low as possible for small business owners.
Interest rates for SBA 7(a) loans are set based on the daily prime rate, which adjusts based on actions taken by the Federal Reserve, plus a lender spread. The lender spread is negotiated between the borrower and the lender and determines whether a fixed or variable interest rate loan is best. The SBA has controls in place so the maximum spread lenders can charge based on the size and maturity of the loan does not get out of control.
A lender providing an SBA loan may also calculate interest rates using the one-month London Interbank Offered Rate plus 3% or the SBA’s optional peg rate instead of the daily prime rate. Which benchmark or index your loan is tied to is part of the loan process when the underwriting department determines how much you qualify for.
Working with an online lender like Biz2Credit, you have access to funding specialists who can walk you through these details.
For informational purposes, let’s talk through two hypothetical scenarios and ideal conditions which demonstrate the power of a variable interest rate loan on small loan balances and large loan balances.
First, variable rates typically start with a lower interest rate than fixed (typically fixed-rate loans have higher rates because you’re paying a premium for stability) so right out of the gate your monthly loan payments are lower. For small loan balances and shorter repayment terms, any fluctuation in the benchmark interest rate or index your loan is tied to will have a minimal impact on your monthly payment total over the life of the loan.
Even if you have a low risk tolerance, the risks with a variable rate in this scenario are minimized and might make sense for your small business because your monthly payment amount shouldn’t increase too much (read on to see when this is not the case).
Second, for entrepreneurs with a higher risk appetite, a variable interest rate on a large loan balance and a longer repayment time frame can also make sense but have a bigger risk. Similar to the first scenario, your initial monthly payment will be lower than a fixed-rate loan. Even if your variable rate goes up, since you’re starting at a lower rate, your new rate might still be lower than the fixed-rate if the macroeconomic environment is favorable (meaning interest rates are not rapidly rising).
Based on your lender, loan type, and personal credit score, you might have the ability to refinance your variable rate loan at a later time. The strategy then becomes, when you initially take out your variable-rate loan, try to lock in the low rate for as long as possible before it adjusts. Then, when you’re close to the loan going through an adjustment, get a sense of where the benchmark interest rate or index your loan is tied is at (is it going up, down, or flat). This will give you a sense of how much your interest rate may adjust up, down, or not that much.
In this second scenario, you’re required to take a more active role by reviewing your loan options periodically and understanding your eligibility to refinance, to make the necessary adjustments. The adjustments might be: if interest rates are rising rapidly, consider refinancing to a fixed rate, if interest rates are going down, consider taking no action, if interest rates are flat, consider taking no action. This strategy is similar to one on the personal loans side, an adjustable-rate mortgage on personal real estate by locking in a lower rate and then refinancing later.
The previous two scenarios demonstrate the hypothetical power of a variable interest rate loan. However, in certain economic environments, a variable interest rate loan can drive up your monthly loan payment and you might find it hard to pay back the loan and possibly default.
A rising interest-rate environment, like the one we are in as of this writing, can make the variable interest rate strategy very challenging to navigate. When the economy becomes overheated, inflation and asset bubbles start to happen which can threaten economic stability. That’s when the Federal Reserve steps in to raise interest rates, which is a tactic to cool the economy down, lower inflation, and get economic growth back on track.
When the Federal Reserve raises the federal funds target rate (which your variable rate loan might be tied to), the goal is to increase the cost of capital throughout the economy to lower inflation. This action results in higher interest rates making loans more expensive for businesses, and small business owners end up spending more on interest payments. When business loan interest rates go up, this puts operational challenges on a small business.
In a situation like runaway inflation, which is when inflation surges, the Federal Reserve will raise the federal funds target rate just as fast to try and tame it. This means it’s possible that your loan repayment amount on a variable interest rate loan can spike. Before opening a variable interest rate loan, it’s critical to understand rate increase caps.
For large-balance loans, any adjustments up to your interest rate will impact your monthly payment more than if you have a small-balance loan.
Although the above is a worst-case scenario, cost-sensitive startups might not be able to absorb the impact of the increased monthly payment. With lower working capital at their disposal, the business may be unable to operate. Due to the uncertain nature of variable interest rate loans, having a business plan in place is important. This will ensure you have through these worst-case scenarios. But keep in mind that there are many factors when coming up with your small business financial plan, this is just one.
One tactic to hedge against this risk is to open a business line of credit. In this worst-case scenario, a business line of credit can give a small business the ability to keep operating by tapping into the credit line for long enough to hopefully make the necessary adjustments. Similar to credit cards, the line of credit only adds to your total amount of debt when it is used.
In the end, variable interest rates can be a great option and resource during certain times, particularly when you think interest rates will stay flat or drop in the coming months and years. However, during times of inflation when interest rates are expected to climb, taking on a variable interest rate comes with a lot of added risk. This doesn’t mean you cannot take on a variable interest rate loan during these periods, but it means that you have to make sure you plan for the possibility of a much higher interest rate down the road. As always, it’s all about planning – the more possibilities you plan for, the less risk you will be surprised in a negative way in the future.