When the Federal Reserve raised interest rates in mid-March, analysts and investors alike were left scratching their heads. What does a 0.25% increase actually mean, and what will the impact be?
These occasional rate hikes can be scary for small business owners. After all, no one wants to see an increase in their interest rates, and small businesses have a wide variety of complicated financial products to choose from.
Will you feel the rate increase with every financial decision? Not necessarily. But it’s important to keep these terms in mind as you apply for financing to grow your business.
What’s the Fed Funds Rate?
The federal funds rate is the rate that banks charge each other for short-term, overnight loans. Banks make these loans to each other so that they can meet the reserve requirement—that is, the amount of cash they’re required to keep on hand each night. The Fed adjusts the federal funds rate based on the overall health of the economy so that they can control the rate of bank lending and protect against inflation.
An increase in the fed funds rate is usually mirrored by an increase in what’s called the prime rate.
The prime rate is the rate that banks charge to lend to their most creditworthy customers, and it’s used as a benchmark to determine interest rates more generally.
So if you took out a loan today, your interest rate might be determined by adding a few percentage points onto today’s prime rate. The number of points they add depends on a variety of factors, including your credit rating.
So why are the fed funds rate and the prime rate linked?
Because banks are businesses too!
They still need to make money on every loan they make. When the fed funds rate is increased, it becomes more expensive for banks to lend money to each other. To recoup that cost, they increase the prime rate—and in turn, interest rates go up across the board, making your loans a bit more expensive.
How Does All of This Impact Your Small Business?
Luckily, these changes don’t happen overnight. It takes a little while to really feel the impact of a small rate hike like this on your business.
But here’s the catch: The Fed is expected to raise rates two more times in 2017. So it’s important to consider how your business will be impacted by this trend of rising interest rates.
It’s inevitable that rate increases will influence your financing decisions—and they should! The impact of the rate hike will differ depending on the type of loan product and contract you’ve secured.
In that vein, there are two types of interest rates you need to know: fixed and variable.
Fixed Interest Rates
A fixed interest rate loan is a loan in which the interest rate remains fixed for the entire term, no matter what happens to market interest rates. That means that if you’ve locked in that rate, your payments will stay the same for the duration of the loan term.
If you’re currently paying off a loan with a fixed interest rate, the fed funds rate increase won’t impact your interest payments.
On the other hand, if you’re paying off a short-term or expensive loan product and you’re interested in refinancing, it’s smart to lock in rates before they rise again. Given the interest rate environment, you should act sooner rather than later to secure a lower fixed rate.
Variable Interest Rates
A variable interest rate loan is a loan in which the interest rate is tied to market interest rates (the prime rate). For example, instead of a fixed interest rate of x%, your interest rate might be quoted as prime rate + 3, which would make your interest rate 3% higher than the prime rate.
This type of loan can be really advantageous if market interest rates are on the decline. But of course, there’s a catch—as the fed funds rate and prime rate both increase, your variable interest rate loan becomes more expensive.
Variable interest rate credit cards also have APRs (annual percentage rates) that are tied to the prime rate. And here’s the kicker: The rates on variable interest credit cards can change without advanced notice.
Because of the payment structure for business credit cards differs from traditional term loans, it’s especially important to pay attention to the “terms and conditions” section of the contract quoting your interest rate.
Will every business owner feel a pinch due to this rate hike? Probably not.
But there are ways to minimize the impact of rising rates on your business. That starts with evaluating the interest rate environment as part of your financial decisions.
When you’re choosing between a fixed or variable interest rate loan product, ask yourself how likely it is that rates will increase during the term of your loan. The answer might guide you toward a fixed rate if market rates are going up—or a variable rate if they’re falling.
Reading the fine print can also help protect you from unexpected payment increases. For example, if you have a business credit card, you should be aware of how your interest fees will be affected by fluctuations in the market rate so that you can pay off your balance accordingly.
When it comes to business funding, always stay informed. Many factors can influence cost and eligibility, and the more you know, the better decisions you’ll make for your business.
This article was originally published on the Fundera Ledger on April 7, 2017.