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The Federal Reserve’s impact on interest rates

Interest rates that a small business owner or their customers pay to borrow money are affected by the federal funds rate, which is updated by the Federal Open Market Committee (FOMC) up to eight times each year. The Fed controls the federal funds rate as a means of managing monetary policy and stabilizing the U.S. economy. The federal funds rate is set as a target range for commercial banks that are lending and borrowing their excess reserves, although commercial banks aren’t required to adhere to it. When the federal funds rate is increased or decreased, the cost of borrowing money changes for everyone which impacts small businesses in several ways that we discuss in detail later.

2022 Federal Funds activity

On September 21, 2022, the Central Bank, called the Federal Reserve, announced in a press conference that it was raising the target federal fund rate by 0.75 percentage points. This was not the first time rates were increased since last year. The rate had already been increased four other times in 2022, including two other increases of 75 basis points each in June and July. Three significant point increases in the target rate means that the federal funds rate is 3 to 3.25%,  the highest it’s been since 2008. When the federal funds rate is increased, the Prime Rate also increases. The Prime Rate typically stays about 3% above the federal funds rate. The Prime Rate as of October 1, 2022, is 6.25%.

So, why is the Federal Reserve raising rates again? The Fed hikes the rate to combat skyrocketing inflation rates and minimize drastic changes in the Gross Domestic Product (GDP). The inflation rate on August 31, 2022, was reported at 8.26%, which is the highest it has been since 1981 when President Reagan cut taxes. The country is seeing high consumer price index (CPI) and unemployment rates which is translating to a declining housing market and the most apprehensive spending patterns since the height of the pandemic and news of the war in Ukraine.

The inflation rate and GDP are two of the most reliable tools used to measure the overall economic health of the U.S. because when those rates are high the economy suffers. Interest rates go up, which decreases the borrowing and spending power of the public. The cost of products and services increases to combat increased supply costs, causing business owners and homeowners to fear a recession.

How the most recent rise in interest rate affects small businesses

The increase in the Fed interest rate affects large and small businesses because it decreases their earning potential. The cost of labor increases for business owners because employees need to compensate for their rising costs of living. The prices for inventory, raw materials, and shipping increase because of increased costs to those suppliers. The monthly payments on business credit cards and other types of revolving credit increase and negatively impacts the business’s cash flow.

The revenues of small businesses also decrease when interest rates are high because customers spend less money. Consumers are paying more for necessities like fuel and groceries during times of high inflationary rates, which means many of them are spending less money on retail products and professional services. Customers that rely on credit to make large purchases are discouraged by the rising interest rates and may shop around for lower prices or delay their purchases. Entrepreneurs are forced to either pass the increases on to their customers, close their doors, or look for business financing options.

Interest rates and investments

Rising interest rates affect the value of a small business’s investments. The stock market is negatively impacted when the Fed increases interest rates because investors anticipate an economic slowdown and sell their investments. When the stock market is down, the value of investments for small business owners is lowered. The value of bonds that an entrepreneur may have also decreases with the market rate.

While the value of a business’s investments decreases as a result of the increased Federal Funds rate, small business owners can earn more interest income due to higher treasury yields. The Fed rate also dictates the annual percentage yield (APY) which affects the interest paid on savings accounts, business checking accounts, money markets, and CDs.

Interest rates and small business loans

Many small business owners wonder if the increased federal funds rate can affect their current debt payments. The answer depends heavily on the repayment terms of the loan. Business loan terms are determined by lenders at the time a potential borrower submits a loan application. The repayment terms dictate the total number of payments a borrower will need to make to repay the debt and also how much borrowing costs they’ll pay. Interest on the loan makes up the greatest percentage of a borrower’s financing costs, as lower interest rates mean the borrower will pay less for borrowing the money.

Interest rates can be fixed or variable. A fixed-rate interest loan has an assigned interest percentage at the time of funding. The interest rate stays the same over the life of the loan. While fixed rate loans make for predictable repayment schedules, they may cost the borrower more money over time if the market rate on Main Street drops.

Variable interest rates fluctuate over the repayment term depending on the current market rate, or prime rate. Typically, loans with variable rates have a set interest rate which is then added to the current market rate. When the Feds increase the federal funds rate and interest rates rise, borrowers pay more money for the funds they received. Whether or not the latest rate hike from the Federal Reserve affects existing loans depends on if they are fixed rate or variable.

Types of small business financing options that commonly have variable interest rates include:

SBA Loans

SBA loans are a small business loan option where the U.S. Small Business Administration guarantees a portion of the borrowed funds. Since the government backs these loans, they are easier for borrowers to get and carry less risk for the lenders. SBA loans can be issued by traditional lenders, like banks and credit unions, or by alternative lenders, like Biz2Credit. Common SBA loan programs include the SBA 7(a) loan and SBA Microloans.

SBA loan programs can either have variable or fixed interest rates and are based on the Fed rate, although the SBA sets a maximum interest rate approved lenders can charge. So, if the SBA allows lenders to charge an interest spread of 2.75% and the prime rate, used as a benchmark, reaches 6.25% in response to the raised federal fund rate, borrowers will be paying 9.0% interest on those SBA loans. 

Business Credit Cards

Business credit cards can be a great financial tool for new business owners or established companies. They allow entrepreneurs to make the purchases they need to meet business needs while also building a good business credit history. Some business credit cards have rewards programs for their members, so cardholders can earn points and save money on certain business expenses. Credit cards in the business’s name do not impact the available credit or personal credit score of the business owner. Interest rates on credit cards are usually variable, so as the federal funds and prime rates increase, credit card interest rates increase as well. Small business owners that have a variable interest credit card may see an increase in financing costs in the next billing cycle following the Fed officials’ rate increase in September 2022.

Business lines of credit

A business line of credit is another type of revolving credit, like a business credit card. Lines of credit work when a borrower is approved for a maximum credit limit and can draw funds anytime they need additional working capital. Business lines of credit are beneficial to businesses because they give the borrower access to fast cash, and they help build good business credit. Most lines of credit have a variable interest rate, so they will be impacted by the increased federal funds rate. Higher interest rates can increase monthly payments and add more time to the repayment schedule.

Types of small business financing options that commonly have fixed interest rates include:

Term loans

Term loans are a traditional type of business financing where the borrower receives a lump sum payment upfront and repays the debt according to a predetermined repayment schedule.  Term loans can be approved through a traditional bank or online lender, like Biz2Credit. Term loans may have a fixed interest rate or a variable interest rate. The payments and repayment terms for borrowers that have a fixed interest rate term loan will not see any change to their payments considering the Fed’s rate hike.

Commercial Real Estate loans

Commercial real estate loans can have either a fixed interest rate or a variable rate. Since they are intended to fund the large purchase of land, buildings, or homes, real estate loans are low risk for lenders because they are secured by the asset they financed. Mortgages with variable rates, also called adjustable-rate loans, are already seeing record high rates over the last two years, and can expect mortgage rates to continue to rise with the Fed increases. The number of variable rates negatively impacts both business borrowers and the consumer housing market.

Managing future rate hikes

Small business owners, lenders, and consumers are all wondering what’s next for the federal funds rate and hoping there’s a soft landing on the horizon. Previous forecasts showed that financial analysts and Wall Street economists predicted the rates would soon come down, a recent CNBC survey revealed during a news conference that the Federal Reserve is likely to continue to raise interest rates through 2023. Economic projections are now stating that the rate is expected to go as high as 4.25% by the end of the year if the rate increases in November and December are also three-quarters of a point. The same survey revealed that the rate hikes have business owners bracing for a recession.

Analysts are predicting that President Joe Biden and the policymakers at the Federal Reserve will continue to aggressively fight inflation as they prepare for midterm elections, which will lead to more rate hikes. While small business owners prepare for an economic downturn, there are some steps they can take to manage high interest rates.

Refinance

Review the repayment terms on current business debts. If your small business has a variable rate loan, consider working with a financing expert to see if refinancing into a fixed-rate loan is an option for your business.

Pay down

Even after the third 75 basis point rate hike, interest rates are predicted to continue rising. If your business has balances on a credit card or line of credit, consider using available cash to pay those balances down before the rates increase again.

Improve Creditworthiness

The economic downturn makes it hard to stay afloat, but as rates continue to rise, it is more important than ever to monitor credit scores. Be sure to make debt payments on time and consider lending options carefully before allowing several hard inquiries on your credit report. Improved creditworthiness will only increase your approval odds in the future for lower interest financing or refinancing.

Final Thoughts

The recent rise in the federal funds rate impacts small business owners with higher interest rates and lower annual revenues. While the increase in September marked the third .75 point increase this year, analysts are only predicting the rate to continue to increase through 2023. To combat the effects of rising interest and inflation rates, small business owners can work with Biz2Credit to learn about their financing options to increase working capital or refinancing options to decrease borrowing costs.  Vista Pharmaceuticals turned to Biz2Credit when they thought lower-interest financing was not an option and were pleasantly surprised to secure a low interest SBA loan.

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