Fixed Interest Rates vs. Variable Interest Rates During Inflation



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As a business owner during a time of unprecedented inflation, you may be wondering how inflation will impact your ability to get a business loan at a feasible interest rate. You may also wonder if it’s best to finance your business venture with a fixed interest rate loan or a variable interest rate loan. This guide will help sort things out for you and show you the pros and cons of each loan type.

What is inflation?

Economists define inflation as the rate at which the prices of goods and services increase over time.

Inflation is sometimes the result of a supply chain imbalance. During inflation, there is typically not enough goods or supply to meet demand. What occurs is that people will pay more for items, resulting in inflation. As inflation increases, your purchasing power is decreased.

Supply chain problems have been a common issue since before the pandemic, but COVID-19 exacerbated the issue. As a result, the U.S. economy has seen inflation soar.

From 1960 to 2021, the average annual inflation rate was around 3.8%. But inflation surged in 2021 to 4.7%. The United States recently hit its highest inflation level in 40 years when annual inflation reached 8.6% in May 2022.

As a general consumer and business owner, you have probably noticed inflation impacting everything from gas prices, to the housing market and home prices, to how much you’re paying at the grocery store.

Rising interest rates due to inflation can impact your personal finances, including savings accounts, bonds, student loans, personal loans, lines of credit, adjustable-rate mortgages, and fixed-rate mortgages (at the onset).

But inflation can also affect your business. According to a Goldman Sachs small business survey published in April 2022, 28% of business owners said the biggest problem impacting their company was inflation. Moreover, 88% of them said that inflationary pressures on their business have increased more than they did in January 2022, and 95% of those business owners believe inflation will persist for at least another six months. Another 80% of those surveyed said that inflation has negatively impacted their business in recent months.

How does inflation impact your business?

It’s clear that rising inflation directly affects your business, and how you deal with it can impact your profit margins and cash flow. With inflation, the following are typically seen in small businesses.

Your business will have increased costs.

As everything in the economy goes up in price, you’ll pay more for inventory, supplies, services, and labor costs. Simply put, it costs you more to do business, so it’s important to find ways to lower whatever expenses you can.

Your small business may have to slowly raise prices to offset expenses.

You may have already had to pass some of the increased costs of your products and services on to your customers and clients. Many business owners find that this is the only way to survive during times of inflation, but sometimes increased prices result in fewer sales.

You have to work harder to manage profit margins for your business.

As costs rise, your business’s profit margins are directly impacted. Without the appropriate actions, your business could net less profit. For your business to maintain an acceptable profit margin, you have to become savvier at figuring out how to counter inflation. This could involve finding a less expensive vendor, consolidating or refinancing business debt, or going with a supplier that is closer to where you operate your business to save on transportation costs.

What happens to interest rates when inflation increases?

When inflation is persistently increasing, the Federal Reserve typically raises interest rates to help counteract or manage inflation. The Reserve has raised its federal funds rate three times thus far in 2022, with the most significant increase occurring in June.

This benchmark rate impacts how much you have to pay back when borrowing money and how much interest you’re paid to save money.

By increasing interest rates, the central bank is betting that people will slow down their spending so that supply and demand balance out. Then, as inflation falls, they can lower interest rates back down to a more affordable level. But that takes time, sometimes a year or more.

Raising the federal rate also influences the interest rate that is charged when you get financing, whether it’s to buy a house, a car, or take out a business loan. An increase in rates can also affect your interest rates on credit cards.

Unfortunately, the Federal Reserve has signaled that more interest rate hikes will happen in 2022.

How can inflation affect my business loan?

Whether or not inflation will directly impact a business loan will depend on one of two things: whether you have a fixed interest rate or a variable-rate loan. If you currently have fixed-interest rate business financing, rate changes shouldn’t affect your loan.

How do fixed interest rates work?

Fixed interest rates work just like it sounds, i.e., your interest rate is locked in and remains the same for the entire course of the loan period, regardless of the state of inflation.

Since you will pay the same amount each month on the loan, it’s easier to budget for a fixed-rate business loan than for a variable rate loan. Having a fixed interest rate also takes the guessing game out of how much business financing will cost you over the life of the loan.

Fixed-rate financing seems more appealing during times of inflation because you know exactly how much you’re going to pay back on the loan. While everything is increasing, including how much you’re having to pay to retain employees, supplies, inventory, etc., your monthly business loan payments remain the same.

Fixed-rate loan benefits

  • Business owners know their exact monthly payment no matter what the market conditions are.
  • The interest rate will stay the same, even during high inflation and times of rising interest rates.
  • Fixed-rate loans are a less risky option for longer-term loans.

Fixed-rate loan disadvantages

  • When interest rates are lower, a borrower may end up paying more interest with a fixed-rate loan. With that in mind, a fixed-rate loan may not be the best if interest rates fall (unless you refinance).
  • Fixed-rate loans tend to be less flexible. For instance, if you need a line of credit, you won’t be able to get a fixed rate.
  • There may be a pre-payment penalty if you pay your loan off early or refinance. Other fees could be charged that might offset the benefits of a fixed-rate loan.
  • Depending on the market conditions during the entirety of the loan, fixed-rate loans may end up being more expensive than variable interest rate financing.

How do variable interest rates work?

Variable interest rates tend to fluctuate and are based on the prime rate set by the Federal Reserve.

The Fed’s monetary policy consists of courses of action they can take to promote stability in the economy by maximizing employment, lowering prices of goods, and moderating interest rates in the long term.

One way they do this is by raising interest rates when inflation is high and lowering interest rates when the markets become more stable.

Variable interest rates follow the path taken by the Reserve. When interest rates are raised, variable rates also go up. When they’re lowered, variable interest rates go down.

The bottom line is that any type of financing that has a variable interest rate will have payments that vary. Depending on how much rates change throughout the loan, the difference in your monthly payments can potentially be significant.

Variable interest rate loan benefits

  • When interest rates set by the Federal Reserve fall, your loan payments decrease.
  • Quite often, a variable interest rate loan will be lower at the beginning than fixed interest rate financing would be. If interest rates really start to go up later on, refinancing the loan could result in better loan terms, particularly as you improve your credit score.
  • Some variable interest rate financing initially comes with introductory perks, such as low-to-no interest. This is especially common with a variable interest rate credit card.

Variable interest rate disadvantages

  • At the time you first get variable rate financing, your payments might be lower. But loan payments increase as interest rates go up. And there is no way of knowing how high they might go.
  • There is lower predictability with variable rate financing, and it’s more difficult to plan a budget or allocate cash flow for your business if interest rates change rapidly, frequently, or substantially. There’s also the chance that a significant rate change overextends your capacity to pay back the loan.
  • If interest rates rise, loan repayment becomes more expensive.

Is a fixed interest rate or variable interest rate better when getting a business loan?

There is no clearcut answer as to whether a fixed interest rate or variable interest rate is better when financing your business. Many factors must be considered before one can conclude which is best.

For instance, is the type of business financing you’re getting for a shorter-term or long-term need? When financing something over the long term, such as with a commercial real estate loan, there is a greater chance that interest rates will fluctuate significantly over the course of the loan.

On the other hand, it’s easier to predict how high interest rates will go during a short-term loan just based on the rate environment at that time.

Generally speaking, fixed interest rate financing usually will cost a borrower less over time, particularly for long-term loans. Fixed-rate loans also usually have more competitive rates than variable-rate financing.

If you see interest rates increasing or feel that a current fixed rate of interest might be lower than future interest rates, a fixed interest rate loan might be preferable because it is ultimately less risky, particularly if you can lock in a reasonable rate.

But if you commit to fixed interest rate financing and interest rates go down later in the course of the loan, you might end up paying a higher interest rate compared to future variable rates. Conversely, the same holds true. If interest rates get out of hand, you might feel more secure with a fixed-rate loan.

If you’re still not sure which option to choose, you might consider a business credit card for your short-term needs. These often have a 0% interest rate for new customers, but the introductory period can last as little as six months or as much as 18. As we’ve seen in 2022, interest rates can go up more than once in a short time. Once the introductory period is over, the interest rate charged will follow the actions of the Federal Reserve and will typically be higher than a loan, so it’s best not to let the balance carry from month to month.

Getting your business financed during inflation

When getting a business loan, weigh all relevant factors to help you determine which type of interest rate is best for your business needs.

When inflation is occurring, you’ll want to be especially vigilant in evaluating loan companies as one may offer you better terms than another. But a good lender will go beyond loan terms in helping you finance your business ventures.

A funding specialist from Biz2Credit can also help you understand which type of business financing might work best for your business goals.

Just ask Danny Star. Danny reached out to Biz2Credit for help in growing his digital marketing business. With the help of Biz2Credit’s funding experts, Danny was able to better define his needs and goals and understand that a working capital loan was the right type of financing to expand his business.

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