How Interest Rates Affect Businesses

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If you’ve read or watched much news at all, you’ve likely heard how the Fed is hiking interest rates, lowering them or keeping them steady. You probably know it has some impact on the ways companies do their thing, but there’s a good chance you’re also not sure exactly how interest rates affect businesses. Let’s get to know a bit more about what interest rates are and what the news about them means to your small business enterprise.

What Are Interest Rates?

There are actually many different types of interest rates for various financial products and from various banks. The central banks of most major countries also set the rates at which they lend money. When folks talk generally about “interest rates” in the United States, though, what they’re typically talking about is the prime rate.

The prime rate represents the lowest rate at which money can be borrowed from a commercial bank by any person or organization that isn’t another bank or a government. As a general rule of thumb, it’s about 3 percent lower than the Federal Reserve’s funds rate. That’s the rate that the U.S. government loans money to a handful of major banks that they have the responsibility to put the money into the larger economy by lending it to other banks.

As noted, banks lend money to other banks, and this gives rise to the LIBOR, the London Interbank Offer Rate. This functions as the banks’ own kind of prime rate for lending to each other, and it’s also worth tracking if you have the mental space for it. Otherwise, just stick with the prime rate and, in most cases, you’ll be fine.

Does It Need to Be This Complicated?

It’s not as complex as it sounds at first blush. On a nearly daily basis, there is a basic chain of events that goes like this:

  • The federal government loans money to a small number of big banks to provide supply to the larger economy.
  • Big banks then loan money to each other and to smaller banks.
  • Your bank loans money to you and handles other activities.

Why does it work this way? First, there’s always the question of exactly how the government puts new money into the economy. Second, markets need to be able to adjust to supply and demand credit. Third, the government wants to have some control over the economy, especially when it is heating up too much or at risk of crashing.

That third item is a big deal. If the collective viewpoint among folks at the Federal Reserve is that the economy needs a boost, lowering the cost of borrowing is one of the ways to encourage investment from folks who might otherwise stay on the sidelines. Similarly, if the Fed is worried that the economy may be expanding too quickly, leading to an economic bubble or inflation, credit can be forced to the sidelines by making it more expensive for people and companies to borrow. In other words, what the government gets out of it is a small ability to operate the throttle on the economy.

Other Factors

Notably, many economists and policymakers do not feel that the Fed actually ends up with much control of the economy by this method. Some would argue that tweaking interest rates has more to do with the “do something” impulse during times of crisis than with actually fixing things.

While the federal funds rate is controlled by the government, the prime rate — which is the one that matters when we think about how interest rates affect businesses — is a function of the larger credit market. It fluctuates in the same way that the price of gasoline or milk does, but generally in much smaller increments on a month-to-month basis. That’s because credit is just one more thing for which there is both a supply and a demand that have to be matched in order to bring people together to make a deal.

For this reason, there are four other factors that come into play. These are:

  • Default rates — If the bank is worried that a lot of people and businesses borrowing money are going to default on their loans, they’re going to want to be paid more for taking on the risk.
  • Inflation — If the bank expects money to be worthless by the time a loan is paid, they will expect higher rates to make up for the loss in buying power.
  • The larger credit market — When more folks are in the market getting credit, starting small businesses and generally pushing the economy forward, it’s easier for lenders to provide loans at lower rates. After all, they don’t have to make all their money off of one or two highly trustworthy borrowers.
  • Institutional strength — Banks are far from invulnerable to the swings of the economy, and they too worry about bankruptcy the same way small businesses do. Not only does a bank have to worry about its own institutional strength, but it also has concerns that other banks may go under in bad times.

Where Does Your Business Fit In?

You might have noticed a theme in all of this: Banks and governments can only do a small amount to improve the economy, but there are a lot of things that can go very, very wrong. Believe it or not, that’s where your small business fits into the bigger picture. Much of the upside in the economy comes from folks who form small businesses, grow them and put that money back into the system.

The biggest advantage you gain from all of this is that both the bank and the government have a desire to see you succeed. Low interest rates are one of the best ways to let people know that there’s a green light to form new small businesses and to borrow money to make that happen.

Another advantage a small business has is that its own actions can lower the interest rates it will be asked to pay when it acquires credit and takes out loans. This can be accomplished by:

  • Maintaining a good credit rating by paying bills and loan payments on time
  • Keeping accounts open
  • Providing large down payments on loans
  • Having a clear business plan that can be presented to the bank
  • Setting up a shorter repayment schedule

In other words, you have more control over your interest rates than anyone else in the entire chain of money creation. While the banks have to worry about hundreds or thousands of customers and the government worries about an abstraction called “the economy,” you get to focus on a handful of difficult but doable things that can move the needle quite a bit.

How Interest Rates Affect Your Small Business

Let’s circle back to the prime rate. It matters because it installs an absolute floor for the cheapest amount you’re going to get from any bank when you take out a loan or open a line of credit. The prime rate sets how cheaply folks with the best credit ratings can borrow money when they bring low-risk business proposals to a lender. If the prime rate sits at 5 percent, then that’s what you can expect the lowest starting point to be for negotiating your interest rate on a credit account or a loan.

One major negative of this is that it influences when you’ll likely decide to do some specific things. For example, a business that wants to acquire commercial properties might actually benefit from buying them when the economy is at its worst. Sellers will often be motivated to sell cheaply at that moment, but the state of interest rates may make it more expensive than it would otherwise be. The higher cost of capital has to be taken into account, and that may deter you from being aggressive in a down economy.

In fact, this is one of the reasons the government often lowers the federal funds rate. Banks will raise their rates because of increased risks in a bad economy. The government then tries to offset those increases to spur business activity. If banks raised rates and the government did nothing, borrowing could grind to a standstill.

Timing is important, but time waits for no one. It’s nearly impossible to time interest rates perfectly, and that means you will always be guessing to some extent.

Another aspect of this system is that interest rates dictate how much value your company gets from sitting on its own cash. If interest rates are high, it’s worth thinking about spending your money to handle things like renovations. Conversely, as interest rates get closer to zero, there’s an argument for borrowing to fund that work even if you have a large cash reserve. Likewise, when interest rates are higher, collecting interest from keeping money in savings accounts may be more profitable for a small business.

Short-Term Borrowing

Many businesses need to take out short-term loans to cover things like payroll and utility bills. This can occur because:

  • A project has fallen behind
  • Clients haven’t paid
  • Things like heating fuel have to be paid for
  • Inventories haven’t been reconciled
  • Other expenses came up

There’s a solid expectation that everything will be fine in the long run, but a small loan is necessary to keep the lights on. Credit accounts and cards can cover some of these expenses, too.

Short-term borrowing, however, is strongly influenced by interest rates. That means that a company that has to take out short-term loans several times a year is going to incur greater costs than one that can operate off an existing credit line or its own cash reserves.

Variable Interest Rates

Another consideration when it comes to how interest rates affect businesses is when the rate on a loan or an account is variable. This means the rate moves up or down relative to an external number that the bank follows, usually the prime rate.

In other words, a 6 percent interest rate on a line of credit established 10 years ago might go up to 8 percent when rates are hiked. That doesn’t sound like a lot, but when looking at a $2 million debt load, that’s an additional $40,000 per year in the cost of simply maintaining existing financing arrangements. That could very well be somebody’s job that has to be cut in order to meet a debt obligation.

Making the Most of It

Keeping an eye on interest rates is important. Let’s say, for example, your small business took out a fixed-rate loan to cover the cost of a new building. If interest rates go down, it may be to your advantage to refinance the loan and incur a financing charge in order to get years of lower-cost borrowing. By watching rates and doing your best to maintain good credit, you can ensure that your small business has the capital it will need to operate for many years to come.

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