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.
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.
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:
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.
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:
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.
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.
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.
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.
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.
Aion provides cost-effective capital to companies of all sizes. With term loans and revolving credit lines ranging from $10,000 to $2 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.