Many business owners take out loans to fund operations. Extra capital from a bank, credit union, or online lender can provide a foundation for startups, commercial properties for retailers, and ad spending for small businesses. You can use a small business loan for any purpose, but you have to repay the loan, usually in monthly installments.
A loan’s interest rate influences your monthly payment. Business owners take several precautions to get lower rates, such as building business credit and shopping around to find the right lender. It’s natural for a business owner to wonder if they will get a fixed-rate loan or a variable-rate loan since the type of rate plays a significant role in how much you pay back each month. It turns out you can get a loan with a fixed or variable rate, but which one should you choose? We will examine the differences and reasons to consider one over the other.
Business Loans: Fixed vs. Variable Interest Rates
If you need funds and don’t have enough money in the bank, you will probably need a small business loan. While several factors go into a loan, business owners should consider whether they want fixed or variable interest rates. Fixed rates remain static for the loan’s duration, while variable rates fluctuate based on market conditions. A variable rate can rise or drop by a few points over the lifetime of the loan.
What are Fixed Rate Business Loans?
Fixed-rate business loans have consistent monthly payments. For example, if you owe $1,000 for your loan this month, you will continue paying $1,000 for the loan each month until you pay off the entire balance. The great thing about fixed-rate loans is that the payments become easier to make over time. That’s because monthly loan payments don’t adjust to inflation. Companies can raise their prices in response to rising prices, but even as money becomes easier to obtain, the monthly loan payments stay the same.
Example of a Fixed Rate Business Loan
If a business owner borrows $200,000 on a 15-year business loan with a 6% interest rate, the monthly payment is $1,687.71. That’s $1,111 per month without the interest rate, but the interest adds more than $500 to your monthly payment. Business owners can allocate $1,687.71 in their budgets each month to cover this loan payment. This business owner won’t have to suddenly allocate $2,000 for the monthly loan payment. As long as you hold onto the original loan, the payment stays the same.
What are Variable Rate Business Loans?
Variable-rate business loans start out like fixed-rate loans. However, you receive capital that you can use for your business right away, and you don’t have to tell the lender how you will use the money. Most lenders may request a business plan before giving you cash, but it’s up to you how you spend it. The difference is the interest rate’s stability.
While fixed-rate loans have stable interest rates, which result in consistent monthly payments, the interest rate on variable-rate loans can fluctuate based on market conditions. If the Fed hikes interest rates, your variable rate loan’s rate will increase. However, your interest rate can also decrease if the Fed decides to lower interest rates.
Example of a Variable Rate Business Loan
Let’s return to our previous example of a $200,000 small business loan that features a 6% interest rate on a 15-year term. You may believe interest rates are due for a drop because of slowing demand or that the Fed’s due for a dovish stance. Since you are looking at a variable-rate loan, you will start off with a 5.7% interest rate instead. It’s normal for variable-rate loans to have lower interest rates than fixed-rate loans when you take them out. Now you only have to pay $1,655.47 each month instead of $1,687.71 per month, allowing you to save over $30 per month.
Saving $30/mo is better than nothing, but it isn’t life-changing. However, if your loan’s interest rate drops to 5%, the savings get better. Your monthly loan payment is now $1,581.59. You’re saving over $100 each month this way.
This sounds great, but the Fed could continue raising interest rates. Business demand can suddenly rebound, causing banks to raise rates. It’s possible that your variable rate loan will rise to a 7% interest rate. At a 7% interest rate, you would owe $1,797.66 per month. In this scenario, you would have saved over $100 per month if you went with the fixed-rate loan with a 6% interest rate. However, a variable rate loan fluctuates, so you could end up recovering some of those losses relative to the fixed rate payments if the variable rate decreases.
What Determines if a Business Loan is Fixed or Variable?
A business loan’s status as fixed or variable depends on the interest rate. If payments remain the same over the loan’s lifetime, you have a fixed-rate loan. Variable-rate loans feature interest rates that fluctuate based on an index.
Which One is Better for Your Business?
Some business owners don’t have a choice. A variable rate loan could be your only path to financing since they are easier to get. If you opt for a business credit line, you’re almost guaranteed to end up with a variable rate, but some of these financial products have fixed rates. However, the higher barrier to entry for fixed-rate loans doesn’t necessarily make fixed-rate loans better choices in all cases. Both loans can help your business, and it’s important to assess the situation before deciding on a loan.
Loan Length
Variable-rate loans start off with lower interest rates, but if interest rates rise, you could end up paying more for the loan. However, it takes time for a variable-rate loan to adjust to rising interest rates, and you may get away with several monthly payments before seeing an increase. With this in mind, a business owner might save money with a shorter-term variable-rate loan. If you have several years on your loan, a fixed-rate loan may make more sense. Even if interest rates find a way to go up, a fixed-rate loan keeps you safe. Short-term variable rate loans can help business owners save money before a significant interest rate hike.
Risk Tolerance
Variable-rate loans are riskier but can save you money. Interest rates aren’t guaranteed to go up, and they can even decrease while you hold onto the loan. Fixed-rate loans are less risky and allow you to make predictable monthly payments. For businesses operating on thin profit margins, an unexpected rate increase can further strain their profits.
Potential Future Interest Rates
The future direction of interest rates matters a lot if you take out a variable-rate loan. Business owners who believe interest rates will decline in the future can benefit from variable-rate loans. You can also opt for a fixed-rate loan if you believe interest rates will increase in the future.
Which One Should You Get: Fixed or Variable?
Business owners who need financing will have to consider which type of loan makes sense for them. A variable-rate loan can help business owners with short-term needs who believe interest rates will decrease in the future. For some business owners, a variable-rate loan is the only path to financing. On the other hand, a fixed-rate loan makes more sense for business owners who want to make predictable monthly payments and not have to worry about what happens with interest rates. These business owners can always refinance their loans if interest rates drop.
