In this article, we cover:
Business loan interest rates are always on the move. Macroeconomic conditions impact small business loan interest rates positively (rates go down) or negatively (rates go up). On the heels of the pandemic which saw unprecedentedly low interest rates, the United States is starting to return to a semblance of pre-pandemic normal. As we transition back, inflation has taken root due to several factors, and the Federal Reserve is trying to combat it. This article explores how interest rates for small business loans are being impacted and where rates might be heading in the immediate-to-short term.
Current Inflationary Environment Explained
If you were to open an economics textbook to the part where inflation is explained, you might read something like this: when the economy becomes overheated, inflation and asset bubbles start to happen which can threaten economic stability. When prices rise, your dollars buy fewer goods and services. Inflation causes a reduction in the purchasing power of your money
In the parlance of our times, inflation is when the price of goods and services go up. In our current economic environment, the prices of goods and services are rising very fast very quickly, and seemingly impacting everything. From a gallon of milk at the grocery store to used cars, to airplane tickets, and everything in between. Your money doesnât go as far as it did last year.
To understand why inflation is rising so fast in our environment, we need to close the textbook and look at whatâs happening in the world. In no particular order, below are some of the major factors causing inflation to go up:
- Many consumers have a lot of cash in their savings accounts right now from the government’s Covid-19 stimulus programs which put money in the pockets of consumers
- Now that Covid-19 restrictions are fading, or gone entirely, consumers are opening up their wallets and spending more on services, driving up prices for experiences like going out to dinner or taking that vacation thatâs been put off since 2020
- During the height of the Covid-19 pandemic, the federal reserve lowered interest rates making it incredibly cheap to borrow money. Lower rates were available for several years up until very recently
- The low interest rates from the Federal Reserve made borrowing cheaper which incentives consumers to make big purchases. For example, lower interest rates mean lower mortgage rates. With lower mortgage rates, many American consumers could now enter the real estate market and become home buyers. Because there were now so many people looking to become homeowners, coupled with historically low housing inventory, this caused the prices of homes to rise dramatically. Additionally, existing homeowners experienced a spike in home equity, while many sought to refinance their existing mortgages to lower their monthly payments
- Supply-chain disruptions have persisted across the global economy due to the Covid-19 outbreak in China. For example, key components, parts, and supplies for the automobile manufacturing process are in short supply. Short supply increases demand for the available parts, which increases the price of the parts, which in turn increases the price of the car
- When Russia, one of the world’s largest oil and gas producers, invaded Ukraine, it put tremendous pressure on energy prices, and oil and gas prices have gone up sharply because of it
- Truck drivers’ salaries have risen because there is a shortage of them. Fewer truck drivers mean there is an increased demand for truck drivers, which means their salaries go up, which means the cost of shipping goes up, which means the cost of the products they ship goes up. Also, the environment has emboldened truck drivers to demand even higher salaries
- Seaport slots and warehouse spaces are all in short supply, leading to costly delays and rising shipping rates for goods
The added costs, at every step from production to sale, lead to price increases for consumers. When you add in a global pandemic and a war, inflation has the perfect environment to grow out of control.
How and why the Federal Reserve combats inflation
The Federal Reserve’s primary tool to combat inflation is raising interest rates. This tool attempts to cool the economy down, lower inflation to its current 2% target, and get economic growth back on track without triggering a recession. The Federal Reserve is currently moving rapidly to make borrowing more expensive (i.e., raising rates).
When the Federal Reserve raises the federal funds target rate (to which small business loan interest rates are typically tied), 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 similar to our current environment, the Federal Reserve will raise the federal funds target rate just as fast to try and tame it.
An example of how raising rates can lower inflation
Suppose there are 10 advertising agencies all with plans to expand, and all 10 need a graphic designer. If interest rates are very low, as they were during the Covid-19 pandemic, all 10 advertising agencies might take out a small business loan and use the money to hire a graphic designer. All 10 agencies are now competing for graphic design talent, which creates a marketplace where they are outbidding each other for the talent. This results in increased salaries, which results in increased prices the advertising agency will charge, which results in increased prices their customers will charge to pay the agency.
If the Federal Reserve raises interest rates, making small business loans more expensive, a small business might think twice about taking out a loan. Suppose now only 5 of those advertising agencies will take out a loan to hire graphic design talent. This reduces demand for talent, which reduces pressure on salaries, which reduces their prices, etc.
The Federal Reserve faces a very difficult balancing act when raising interest rates. They need to raise interest rates aggressively to bring down inflation, but if they raise rates too much, all 10 advertising agencies in our example above might decide not to expand, not hire any additional talent, which in turn causes a contraction of their business and the economy at large.
Impact on business loan interest rates
A small business loan is a cash infusion where a small business receives a lump sum of an agreed-upon dollar amount from a lender. This cash improves cash flow and is vital to the success of a small business as it helps them expand or maintain operations. Rising interest rates increase borrowing costs for companies, weighing on economic activity, and causing small businesses to think twice about trying to open a loan.
When the Federal Reserve raises interest rates, small business loan rates go up, which makes the monthly repayment amount go up. For more information about business loans, review our article Information About Small Business Loans Every Small Business Owner Must Know.
Strategies to navigate a rising interest rate environment
Conventional wisdom suggests a fixed-rate loan in a rapidly rising interest rate environment is a sound strategy. Although you might be locking in a rate that comparatively looks bad to what rates might have been a few months ago, you are avoiding the volatility variable-rate loans can experience in this type of environment. Despite the volatility of variable-rate loans in a rapidly rising interest rate environment, they do have their benefits (such as lower initial rates which you can later adjust to a fixed rate by refinancing) and itâs important to understand variable interest rates as a small business owner.
Another tactic to hedge against the risks of a rapidly rising interest rate environment is to open a business line of credit. However, this strategy is only relevant if you open the business line of credit before rates have gone up. Take a deeper dive into this strategy by reviewing our article titled Why should a small business open a business line of credit?
Will business loan interest rates rise soon?
The Federal Reserve recently implemented its second consecutive interest rate increase of 0.75% during its July 2022 meeting which was also its fourth consecutive rate hike. Jerome Powell, the head of the Federal Reserve, is in charge of leading the strategy of fed interest rate hikes. As discussed above, raising the federal funds rate is the primary tool the Federal Reserve has to slow down runaway inflation without creating a recession.
The four consecutive rate hikes take the benchmark borrowing federal funds rate up to a range of 2.25%-2.5%. This rate impacts the interest rate banks and lenders offer on small business loans. At the beginning of the year, the rates were hovering around 0%.
The Federal Reserve aims for inflation of around 2%. This means it views a 2% inflation rate as healthy for the economy. In June, inflation was recorded at 9.1%, much higher than expected, far off from the Federal Reserveâs target of 2%, and this continued to put pressure on consumers and interest rates on small business loans.
The Federal Reserve is committed to reducing inflation back down to the 2% level. One might conclude that since the last recorded inflation number in June was 9.1%, and the Federal Reserve has a target of 2%, they will continue to aggressively raise interest rates in the immediate term. Additionally, the second consecutive interest rate increase of 75 basis points signals that the Federal Reserve is deeply committed to achieving its goal.
St. Louis Federal Reserve President James Bullard, a central bank official, said on August 3rd that he anticipates another 1.5% or so in interest rate increases this year as the Fed continues to battle high inflation levels.
Entrepreneurs looking to secure a small business loan (for example, an SBA loan) should consider locking in a rate now before the Federal Reserve potentially raises rates again in the very near future. Whether you are going to obtain a loan from a traditional bank, credit union, or an online lender, now might be a great time to act.
Finding a Lender
Whether you are after a loan to acquire a business, or you have a business that you want to expand, Biz2Credit is a great place to start. Our helpful staff will provide you with exceptional customer service and will work hard to understand the needs of your business, the intended uses for your loan, and the best terms that can be offered. Get in touch today to find out how small business financing can help you.