The economy plays a huge role in how your business functions. The economic environment influences interest rates and can help you either expand or pull your business back. Interest rates typically rise when the economy is strong and are lowered when the economy is sluggish. When rates are lower, consumer and business spending can boost prices of assets. If you are a business owner, it is crucial to understand the ways that interest rates affect and influence how your company operates.
What is an Interest Rate?
An interest rate is expressed as a percentage that describes the amount a lender charges the borrower to get access to capital. The Federal Reserve affects interest rates by setting the federal fund rate. The federal fund rate is the interest rate that a bank must pay another bank to borrow funds. The Federal Reserve manages the money in the economy and dictates the interest rates for business loans. They add money to the economy to lower rates and make loans more accessible to companies. The Fed lowers or raises interest rates to keep employment high, keep prices steady, and to regulate interest rates.
Before determining your interest rate when you are seeking a loan, the bank or lender will consider your credit history and the loan you desire first. Your credit plays a big role in the rate you get so if you have a good credit history and score, you will face lower interest rates.
Impact of Interest Rates on Small Businesses
Interest rates can affect the growth plans of companies. They not only affect loan payments but also have an impact on your ability to secure funding.
Increased Prime Rates
Increased interest rates also affect prime rates. The prime rate is the lowest at which banks will lend money. If the interest rates go up, then the prime rate goes up as well. When this occurs lenders will increase credit card rates and loan rates making it more expensive for businesses to borrow the funds they need.
As a business owner, it will take you a lot longer to pay off debt and you will need to pay more money when interest rates increase. It will be more difficult to take short-term loans as well to help pay for any unexpected expenses that may arise or expand your business when needed.
High interest rates affect small businesses who most likely operate with limited cash flow. Small business owners must set aside more money to be able to repay any loans and debt which reduces the income available of the business. High rates can also lower the cost of assets, make them harder to sell for capital.
Low Consumer Income
When interest rates rise, consumers have less discretionary income. This means that their ability to buy products and services are reduced so businesses suffer from a decrease in sales. Banks also make fewer loans when interest rates are high which not only affects consumers but businesses too who cut back on spending on new equipment. Businesses that sell luxury products or services may be affected hardest because one of the first things that consumers eliminate when they have less discretionary are luxury items.
When interest rates are low, consumers spend more on products and services and tend to borrow more money as well. The cost of paying back a loan is less when interest rates are low.
Difficult to Obtain Business Loans
There are two ways in which increased interest rates affect your daily financial business operations. First, your long-term debt becomes more expensive. If your interest rates on your loan is variable, your loans can get more expensive. It will be taking you longer to pay them off which can increase the cost of your financing and lower your income.
Secondly, high interest rates also affect short term loans making them more expensive. It is more difficult for a small business to meet their financial obligations if any unexpected expenses arise along the way. Businesses may be unable to deliver products and services to their customers if they do not have the cash flow to continue operating.
Decrease in Business Profits
As a business owner, you will need capital to expand business operations but will have to face a higher cost of capital. Additionally, operational costs can rise too. Your customers will most likely have less discretionary income and you may see a decrease in your business profits.
The interest rate fluctuates depending on the current economic conditions. When the economy is strong, interest rates will be high meaning that loans will be more expensive to take out. When the interest rates are low for too long, banks tend to be more selective of who to approve for a business loan.