Business owners looking to finance their operations have a range of options to choose from. Not every loan will be administered with the same terms and business owners will need to make crucial choices to ensure the best solution for their business. For example, is a small business loan with a variable or fixed rate best for them? Understanding the differences between fixed-rate and variable-rate loans can help small business owners make more informed decisions.
What is a Fixed Interest Rate Loan?
A small business loan with a fixed interest rate is one option available to business owners. Small business loans with fixed rates provide stability and predictability because the interest rate on the loan stays the same throughout the entire life of the contract.
For business owners, this means a steady, unchanging payment amount each month until the loan term is completed. Rates and term lengths vary depending on the lender and the creditworthiness of the borrower, but once the loan is funded, the rate will not fluctuate. A fixed-rate loan means paying the same amount each month over the course of the loan. Fixed-rate small business loans can be found at traditional institutions like banks and credit unions as well as online lenders and fintechs. Is a fixed rate better deal than a variable rate? It depends. Variable rates fluctuate, so a fixed-rate loan could end up being more expensive or less expensive in the end. Many business owners prefer the predictability of fixed-rate loans, especially in rising rate environments.
Pros and Cons of Fixed Interest Rate Business Loans
Like any type of loan, small business loans with fixed interest rates have their benefits and drawbacks. Here are a few pros and cons to consider:
- PRO: Payment Predictability. A fixed-rate small business loan will require the same monthly payment until the term is completed. For a business owner with fixed costs, this predictability is more important than getting the lowest possible rate. Business owners can make decisions knowing exactly what their future liability is when loans have fixed rates.
- CON: May Not Get The Lowest Rate. A small business loan with a fixed rate may not be the cheapest overall offering. Variable-rate loans often start out cheaper than fixed-rate loans for some business owners and if interest rates decline, the variable rate could become even more attractive.
- PRO: Fixed-Rate Loans are Beneficial When Inflation Rises. If inflation is high, a fixed-rate small business loan will become cheaper to finance over time as less and less purchasing power is required to service the loan. If a small business is forced to raise prices 5% to combat inflation, a fixed-rate loan will become easier to pay off over time as more dollars come in.
- CON: Must Refinance to Take Advantage of Lower Rates. Is a small business loan with a fixed interest rate permanently set at that rate? Yes, if rates decline and lower cost loans become available, business owners with fixed-rate loans will need to refinance in order to secure cheaper financing. Refinancing an existing loan isn’t difficult, but often involves an extra round of fees and administrative costs.
What is a Variable Interest Rate Loan?
Not all business owners prefer loans with a fixed interest rate. Sure, having a fixed rate offers more predictability and peace of mind knowing that payments will never go up. But small business loans with variable rates can still be more appealing in certain situations.
A variable-rate small business loan won’t have a constant monthly payment. With a fixed-rate loan, the monthly payment never changes, but loans with variable rates may see monthly costs change throughout the life of the loan. That’s because variable rate small business loans come with a teaser rate that will recalculate automatically once the introductory period concludes. The variable rate will have a base interest rate (i.e. the Fed Funds rate) and a spread that the lender charges on top. If the particular base rate linked to the loan rises, the business owner’s cost to finance the loan rises as well. If the linked interest rate drops, the variable-rate loan will become cheaper to finance.
When is a small business loan with a variable rate the better choice? Imagine a new small business that expects revenue to increase significantly starting in Year 3. In this situation, a loan with a variable rate might make sense. The business owner could choose a variable-rate loan with an introductory period of three years, locking in a low starting rate for 36 months and dealing with potential cost increases when business revenue is stronger. If interest rates are higher in 36 months, the additional monthly costs might be offset by the increase in revenue.
Pros and Con of Variable Interest Rate Business Loans
Small business loans with variable rates have their own pros and cons as well. Here are some important factors to think about with variable-rate loans:
- PRO: Falling Interest Rates Mean Cheaper Payments. Variable-rate loans fluctuate throughout the term based on market rates such as the Federal Funds rate. If a business owner takes out a small business loan with a variable rate and the Federal Reserve lowers interest rates in the following years, the total financing costs will likely be less than a fixed-rate loan of the same amount.
- CON: No Control Over Total Loan Costs. Business owners with variable-rate small business loans are at the whim of market forces when it comes to total costs. Lenders will not be able to tell business owners the total cost of a variable-rate loan since rates are subject to fluctuations in the base interest rate.
- PRO: Ideal for Short-Term Borrowing Needs. Since the introductory rate on a variable-rate small business loan is often cheaper than the rate on a fixed loan, variable loans are perfect for business owners looking to bridge a short-term financing gap. If a business owner projects sales growth to triple over the next five years, a small business loan with a variable rate and a five-year introductory period could be the most efficient financing option.
- CON: If Rates Rise, Variable Loans Could Become Unaffordable. Variability is a double-edged sword and interest rates are difficult to predict. A small business owner who takes out a variable-rate loan could face difficulties if the Federal Reserve raises rates more quickly than anticipated.
What Causes the Base Interest Rate to Change?
The base interest rate is a rate set by government institutions that direct lenders on what to charge business owners for loans. In the United States, this rate is usually the Fed Funds rate, which banks use to calculate their Prime Rates. The Prime Rate varies from lender to lender but is usually 3% to 4% higher than the base rate. For example, with a Fed Funds rate of 0.75% to 1%, the Prime Rate set by a bank could be 4.25%. Rates for loans increase from this point depending on the creditworthiness of the borrower.
Base rates change due to factors like inflation, economic growth, and monetary policy. When inflation is high, too much money is chasing too few goods and services and the Federal Reserve raises rates to stifle demand. Rising rates will change the base rate and make borrowing more expensive. On the other hand, if inflation is low and economic growth is stagnant, the Federal Reserve may lower interest rates to stimulate more demand by cheapening the cost of money. When rates fall, the base rate moves lower as banks and lenders require less financing from borrowers in order to access capital.
In the end, base rates fluctuate due to a number of economic factors. The Federal Reserve might be the controlling mechanism of rates in the US, but they respond to economic data, so the state of the economy will go a long way in determining what the base rate for a small business loan is.
Small Business Loan Considerations
Is a small business loan with a fixed or variable rate better for business owners? The answer, unfortunately, depends on a few different considerations. Small business loans aren’t a one-size-fits-all solution and business owners all have different goals and deal breakers when it comes to their financing needs.
Loan Term
The length of time needed to pay back the loan should play a large role in determining which type of loan to procure. A good rule of thumb is that the longer the duration of the loan, the more at risk it is to changes in interest rates. If a business owner needs a quick, one-time loan for a particular circumstance, borrowing at a variable rate may make more sense. If the business owner is looking for an ongoing financing solution to cover cash flow gaps or grow their business, a fixed rate of interest might be more appealing.
Business Conditions
What are the conditions of the business and the overall market? If the economy is struggling and the Federal Reserve has signaled a willingness to drop rates, a variable-rate loan could become cheaper to service over time. Likewise, if interest rates are rising, fixed-rate loans lock in that cost of borrowing and won’t be affected by further rate increases.
Predictability
How predictable are the sales and profit growth of the company? A business going through a short-term lull might be better suited utilizing the low intro rate of a variable loan to weather the storm. If the business has steady sales and the owner prefers stable, unchanging payments, the fixed-rate loan will be the better bet.
Small Business Loans with Aion
Aion provides cost-effective capital to companies of all sizes. With term loans and revolving credit lines ranging from $10,000 to $5 million, business owners can find the capital they need at a reasonable rate. With transparent pricing and no hidden fees, business owners understand exactly what they’re paying for Aion Capital.
Still not sure what financing is best for your business? Connect with an expert to help you weigh your options.