If you’ve ever accepted a loan from a bank or lender, then you know that you aren’t just responsible for simply repaying the principle. On the contrary, most loans require the borrower to pay interest (i.e. money charged in addition to the loan amount).
An interest rate is normally expressed as a percentage describing the amount a lender charges a borrower for access to capital. But while most of us are familiar with the concept of interest rates, we might not know exactly how banks and lenders determine these all-important figures. As a business owner, understanding how interest rates work—and the impact they can have on your small business—is crucial to protecting your company’s fiscal health in the coming years.
How Interest Rates Work
Understanding that some borrowers will ultimately be unable to repay their loans, lenders charge interest to recoup a portion of their initial investment. Setting consumer and business interest rates begins with the Federal Reserve. The Federal Reserve affects interest rates by setting the federal fund rate (i.e. the interest rate that one bank must pay another to borrow funds). This in turn affects the amount that lenders charge private borrowers.
The Federal Reserve also manages the amount of money in circulation at any given time, and the amount of money in an economic system typically dictates the average interest rate on loans. When the buying demand exceeds the amount of cash in circulation, lenders charge a higher interest rate. On the other hand, when available cash is higher than demand, borrowers typically enjoy lower rates. The Federal Reserve adds money to the economy in an effort to lower rates and make loans more accessible to individuals and companies.
Along with the federal fund rate, individual factors can also affect interest rates for borrowers.
When you borrow money, the bank or private lender will consider your credit history and your desired loan term before determining your interest rate. Credit scores, also known as FICO scores, give lenders insight into a borrower’s financial history. Borrowers who defaulted on loans and credit-card bills will likely face higher interest rates than those with a solid history of repayment. Additionally, long-term loans tend to feature higher interest rates than those lasting just a short period, as borrowers have more time to default when financial problems arise.
Impact of Interest Rates on Small Business
As a small business owner, you likely not only pay interest on the money you borrow, but you also might charge interest when your customers purchase products and services with credit. As a result, fluctuating interest rates can have a profound effect on your company’s fiscal wellness moving forward.
Here are some of the ways in which interest rates affect your small business.
A change in interest rates can have a significant effect on a company’s growth plans. Not only do interest rates affect loan payments, but they also have an impact on your ability to secure funding.
Because high interest rates reduce overall corporate earnings, they may hinder your ability to expand or grow your business. On the other hand, falling interest rates make business loans more affordable. As a result, companies attempt to plan their expansions to coincide with periods of lower interest rates.
In the long run, interest rates can have a profound effect on the economy by limiting business growth. While expansions tend to result in hiring booms, which put more money into the economy, a freeze in business growth can have the opposite effect, decreasing consumer purchases and hindering the economy.
High interest rates can have a serious effect on small businesses, which tend to operate with limited cash flow. When interest rates rise, small business owners must set aside more money to repay loans and other debts. This in turn reduces a business’ available income and can affect its ability to pay receivables. Unfortunately, higher interest rates can also lower the cost of assets, making them harder to sell for capital.
On the other end of the spectrum, interest rates affect the amount of money your customers have to buy goods and services from your company. In the long run, a high interest rate can limit company sales, as money that could have paid for your goods or services is now being diverted to interest payments.
The amount and type of debt a business takes on can determine the impact that fluctuating loan rates have on the company. While small business owners with fixed loans may not suffer greatly when interest rates rise, companies with variable loans, where interest rates fluctuate based on the official rate, may find themselves in trouble.
Most businesses require seed money to grow. While securing financing in today’s economic climate can be a challenge, owners should think twice before accepting a loan with a high interest rate. In some cases, alternative funding may come with too high a price tag. If this is the case, you should consider looking elsewhere to protect your finances moving forward.
To boost your chances at landing a loan with favorable interest rates, check out our article on improving your business credit score.