Understanding Interest Rate Risk for Small Business
When you take out a business loan, it's important to understand how interest rate risk is involved. Learn what factors go into interest rates for business.
If your small business lends or borrows money, interest rate risk is a factor in your finances. This is the risk that interest rates will change, affecting your overall profits. It’s an inherent part of doing business—but understanding how it affects your company is key to determining your type of exposure to the market.
If you’re using business loans to grow your business, for instance, rising rates can impact your ability to secure capital and reinvest. If you’re making loan payments on a variable rate loan, rising rates can increase your payments and affect your cash flow.
Once you evaluate your risk and exposure, you can take steps to protect yourself and your business from economic influences and interest rate swings. Here are some things to consider:
The length and terms of your loan are among the biggest factors of interest rate risk for businesses, on both the lending and borrowing side. Consider a business that lends to customers at set terms: if short-term interest rates go up, that business may have to choose between boosting what they’re charging clients, or refinancing their bank demand debt. Otherwise, they could stand to lose profits.
On the other side, small businesses that take out loans with variable interest rates can face fluctuations in their payments—benefiting when interest rates drop, but paying more when they rise.
If you’ve got long-term debt and no need to borrow more in the near future, rising interest rates won’t be a concern. But if you’re borrowing on a continual basis or taking frequent short-term loans, you’re at more risk if rates increase.
Your small business is likely borrowing money, and as interest rates go up, you’ll pay more money in interest compared to your equity. This can bump up your credit risk and result in higher rates from lenders on new loans. (This is similar to an individual with a low credit score who is subject to higher interest rates on credit cards because they’re at higher risk of defaulting.)
The more a company is borrowing, the higher this risk becomes. As lenders put out more high-risk loans, rates go up because they must account for the possibility of the current loans defaulting.
Foreign Exchange Rates
If your small business has foreign debt, exchange rates can affect the amount of interest you’re paying. If the dollar weakens, you’ll be paying more interest on that foreign debt because the dollar isn’t worth as much. On the flip side, if the dollar increases in value, you’ll be paying less for your debt because a stronger dollar has a larger impact on the foreign market and, in turn, the loan.
This is a big-picture risk. If the economy slows or even dips into recession, it may be more expensive to refinance debt or acquire new loans. This usually coincides with a dip in customer income, because fewer people are financing purchases.
This played out during the recession of 2008 and 2009, when many companies struggled. Consumers felt financially unstable, so they weren’t making as many purchases. This results in a situation where businesses aren’t sure of their incoming cash flow and they’re paying more in interest on debt, in a sort of financial double whammy.
Your Business Products and Services
Rising interest rates can hit customers with debt, too, meaning they must pay more in interest and therefore have less money to spend overall. This may affect your revenues if you sell products that are more of “want” than a “need,” since customers may pull back on extra spending.
How to Reduce Interest Rate Risk:
Small businesses should think through how much interest rate risk they’re willing to take on and whether there are strategies they can incorporate to mitigate the uncertainty. Here are a few tactics:
- Choose a fixed rate loan. Locking in one rate for the life of a loan can help you keep one factor steady should interest rates change before you’ve paid the loan back.
- Strike when conditions are good. A savvy business owner will keep an eye on interest rates and, if possible, look to take on debt when rates are at their lowest or when the dollar is strongest.
- Manage your risk. You may be able to take advantage of different products or loan models—such as interest rate swaps or caps—designed to keep interest rates in check for small businesses.
A Fifth Third business bank representative can help business owners evaluate and choose the loan option that best fits their needs.