Uncertainty and unpredictability can be haunting prospects for a small business owner. When it comes to financing, itâs never a fun place to be in as a business owner to be unsure how your finances will pan out, especially if itâs related to the cost to finance the business.
Unforeseen surprises can hamper a startup company’s growth, so the more that an entrepreneur can count on with a relative degree of reliability, the fewer sleepless nights he or she is likely to experience.
The assurance of a known quantity is a big reason why many small business owners who need to finance their operation would rather opt for a fixed rate loan than a variable rate loan. But are they making the right choice for the best loan? Is a fixed rate loan always the wisest business financing option when a small business owner decides to make payments with credit?
Understanding the distinctions between fixed and variable interest rates can assist you in saving money and meeting your financial objectives.
What is a fixed rate business loan?
Borrowing money with a fixed rate means that the interest you pay on a loan is ensured to remain constant over time. Your monthly payments on a loan do not change during the fixed rate term, even if interest rates in the market fluctuate wildly over the same period of time.
This is why a business will look to “lock in” a certain rate because the loan then comes with the assurance of knowing exactly how much will be required each month to pay back what you have borrowed.
If you borrow $700,000 at a fixed rate of 4.75% for five years, it means that your monthly payments of $1,565 will stay the same every month for all those five years. No matter what rate changes occur in the market during that time you know you’ll be paying $1,565 a month.
This is favorable if the business climate sees any significant increases in interest rates over time because your rate is protected. But what if business loan interest rates fall, perhaps sharply, during the course of those five years? Then your $1,565-a-month repayment doesn’t look so good, because you’re now missing out on lower interest rates that could have resulted in you paying hundreds of dollars less each month.
The term of a fixed rate business loan normally ranges between one and five years. During this period, the interest rate on the business loan will never change.
Even though borrowing money at a fixed rate does mean that a company runs the risk of missing out on potentially lower interest rates — and, with them, smaller monthly payments — for many small business owners that is a risk worth taking in order to ensure an easier and more predictable process of making a budget and planning for necessary expenses according to their business plan.
The interest rate is determined by the small business lenders and is usually based on the prime rate plus a margin. If the prime rate is 3% and the margin is 2%, then the interest rate on your loan would be 5%.
Advantages of a Fixed Rate Business Loan
1) With a fixed rate, the borrower knows at the outset that the size of his monthly payments will not go up during the life of the loan.
2) It becomes much easier to plan accordingly when the precise amount needed for a monthly payment is known in advance.
3) Fixed rate loans frequently come with interest rates that are lower than variable rate loans.
Disadvantages of a Fixed Rate Business Loan
1) There is a risk that you might end up paying more per month than you might have with a variable rate loan if the interest rates when you were approved for the loan end up falling.
2) It is also possible that the fixed rate loan you are approved for has a higher interest rate than a variable rate loan. Because your interest rate wonât decrease, you will instead pay a premium on that rate.
3) Fixed rate loans could be accompanied by more stringent eligibility requirements. Because lenders have a greater likelihood of losing out on more money by not increasing your interest rate when the prime rate increases, lenders compensate by establishing tougher standards for business credit and personal credit with fixed rate loan applicants. The higher your business credit scores and personal credit scores, the lower your interest rate is likely to be.
Advantages of a Variable Rate Business Loan
1)Variable rate loan providers often set a lower introductory interest rate to entice borrowers. If the prime rate doesnât change, or if the borrower is able to make extra payments early on, the loan will end up less expensive than many fixed rate loans. In addition, thereâs always the chance that the prime rate drops, leaving you with a smaller interest rate than you expected.
2)That low introductory interest rate offers up another opportunity. If youâre able to make sizable payments early on, you can get ahead of paying increased interest on the remaining principal when low interest rates go up.
Disadvantages of a Variable Rate Business Loan
1) Variable interest rates can be unpredictable. While the holder of a fixed rate loan can plan months and years in advance, knowing exactly how much theyâre going to owe to their lenders, thatâs simply not the case for holders of variable rate loans. Thereâs no way to precisely predict the financial tides of the upcoming months and years. Not knowing what the interest rate ranges will be on a given date makes variable rates risky.
Although you may be able to afford payments at the low introductory rate at the beginning, if the prime rate rises by 2%, you do not know if your cash flow will be sufficient to sustain your company, or whether youâll be able to meet your business needs without resorting to applying for a higher loan amount–at an interest rate likely to be even higher because of your decreased debt-to-income ratio and higher prime rate overall.
2)The interest rate is beyond the borrower’s control. While your credit will help set your initial interest rate, changes to a variable interest rate on your loan are something you do not have any jurisdiction over. If the Federal Reserve decides to increase interest rates based on world events, it could ultimately affect how much working capital is available for your own small business. That is the risk of a variable rate loan. The longer the repayment terms, the more risk comes with it. Prime rates are not likely to increase too much in the short term, but over the course of several years, thereâs a greater chance for greater variance. So, when you are seeking a large loan at a small variable rate, keep in mind how much risk youâre incurring.
Working capital is the difference between the current assets a company has, including cash and accounts payable, and its current liabilities, which would include bills that need to be paid, salaries, and any debts such as credit cards. If a business has more present liabilities than current assets, the cash shortfall that could result might prompt a business owner to seek a bridge loan.
Fixed or Variable: How to Decide What Type of Loan to Pursue
There are several variables to consider when researching your fixed and variable rate financing options.
If the prospect of big risks makes you squeamish as a small company owner, a fixed rate loan is your best option. Although a variable rate can be less expensive, that isnât always the case. These interest rates can also go up, and that could cost your business enough money to really impact your cash flow negatively.
In many cases, banks and other lenders will offer business loans that carry variable interest rates because of the higher level of uncertainty that is involved in lending money to a business as opposed to an individual. These lenders are also thinking about their risk tolerance when they make these decisions. They are hedging themselves against changes in the interest rate environment. For example, if the Federal Reserve decides to raise interest rates. Because business loans have more volatility than consumer loans, a variable rate provides that level of protection to the lender.
Do you believe, after reviewing interest rates, that rates are likely to go up or down? Rises in interest rates can be impacted by everything from consumer sentiment to inflation to world events half a globe away from your small business. Look at past trends. A variable rate might be more attractive if the economic climate seems benign. If not, go for a fixed rate.
Size of Loan
Variable rates will have a greater impact on larger loans than on smaller loans. If you take out a loan of $300,000 with a loan term of 60 months and an interest rate of 8.0%, your monthly payments will be $6,082.92, and you will pay $64,975 in total interest. If that interest rate goes up by half a percent, your payments would increase $100 more per month, and youâll add $5,000 in total interest payments.
A variable rate on a smaller loan will mean that changes to the prime rate will not affect your monthly payments or total interest costs as much.
Length of Loan Term
The shorter the duration of your loan, the less likely it is that you will experience big fluctuations in interest rates because you will be spending less time paying off the loan. For longer-term loans, there can also be the issue of prepayment penalties, which are sometimes added to a loan to ensure the lender receives a minimum amount of money on top of the loan amount.
Different types of loans are more commonly associated with different rates. A business line of credit is frequently offered at variable rates, although it is by no means the only kind.
Business Lines of Credit and Variable Rates
When a lender provides pre-approved funding with a maximum credit limit, that is known as a business line of credit. If the borrower is approved for this line of credit, funds can be accessed whenever they are needed until the established credit limit has been reached. Very often, this product can have whatâs known as a floating interest rate, or a rate that will change in conjunction with changes in the economy. This is otherwise known as a variable interest rate.
Because the borrower is only paying interest on the amount that he or she withdraws, a business line of credit can be advantageous for business owners who are uncertain of the amount of funding they will actually require, or when they might need it.
The drawback to a business line of credit is that the loan will be at a rate that might be considerably higher than other loan options. How costly that actually would be is heavily dependent on the amount of funds the entrepreneur ends up using.
If a business owner needs to establish a favorable credit history, a business line of credit could help him or her do that.
A seasonal business might favor a line of credit because its cash flow tends to be less consistent from month to month. Manufacturers, service companies, and contractors are other common candidates for lines of credit, which help a business owner meet his working capital needs or bonding requirements without enduring a new application process each time with the help of a revolving line of credit.
SBA Loans and Variable Rates
Many SBA loans–which are term loans guaranteed by the United States Small Business Administration (SBA)–carry interest rates that depend on the prime rate. Others, like the SBA 504 Loan, will have a fixed rate.
The SBA backs small business loans issued through their lending partners to help lower financing rates for business owners. The SBA also can help entrepreneurs to qualify for loans for working capital. The SBA has a loan program with the purpose of making access to capital more attainable to business owners. Featuring low down payments and interest rates that are below market rate, the SBA 504 Loan Program allows small and medium-sized businesses to invest in their facilities and expand their reach, giving them more stake in their community. The SBA 504 program was developed with the intent of aiding small businesses in the creation of wealth. The SBA 7 Loan program is the best option when purchasing real estate for a business, but it can also be used for short-term and long-term working capital and refinancing commercial real estate loans. The key eligibility requirements are based on what the business does to generate income, business credit history, and the location of the business. Your lenders will help you determine which types of business loans are best for you.
Working capital loans secured through the SBA usually mean a larger selection of loan sizes, repayment terms that are lengthier, and interest rates that are not exorbitant. Other means of short-term funding options usually donât offer annual percentage rates as low as SBA loans. Working capital loans can be obtained through a term loan, a business line of credit, a merchant cash advance, or invoice factoring.
Another thing to consider is the length of the loan. The longer the termsâwhether the rates are fixed or variableâthe lower your monthly payments will be as compared to a short-term loan. But it also means you will pay more interest over the full life of the loan. Shorter terms mean higher monthly payments, but also less interest paid over the full term of the loan.
If you need to lower your monthly payments to expedite your cash flow, a longer loan term might be a better fit. But if paying off your loan more expediently is paramount, a shorter term may be preferable in pricing.
Business lines of credit, small business loans, term loans, and invoice factoring are financing options that are more likely to be on the table for a company that has been in business for a year or two than they would be for a company just starting out.
Final Thoughts on Fixed Rate Business Loans
Small business loans â while not easy to secure for new businesses â can be accessed from financial institutions, banks, online lenders, or nonprofit microloans. Loans and other types of financing may come in various forms, some with fixed and others with variable rates and costs. As a business owner, you should weigh the relative pros and cons of fixed rate vs. variable rate loans before you make a decision that could be critical to both the short-term cash flow and the long-term growth of your small business.