Both fixed and variable interest rate loans may help businesses accomplish goals, but choosing between them depends on your goals, circumstances, and risk tolerance.
- A fixed-rate loan keeps your interest rate the same throughout the loan term, offering predictable monthly payments.
- A variable-rate loan changes over time based on market conditions, which may lower or raise your monthly payment.
- Fixed rates may be best for businesses that value stability and long-term planning, while variable rates might benefit those expecting falling interest rates and who are able to absorb an increase in the interest rate.
When some people think of the small business loan process, they picture borrowing money at a fixed interest rate and paying back that loan with equal (but the same) monthly payments until it's finished. Traditional fixed-rate loans do help with planning ahead, but another kind of loan, a variable-rate loan, may offer some other options for businesses. Let's explore the pros and cons of these two interest rate types and the factors that inform choosing one over the other.
Identify the Key Differences Between Fixed and Variable Interest Rates
Understanding how each interest rate type works and what to expect as you pay the loan off may help you make the right decision for your business's stability and growth.
What is a Fixed Interest Rate?
When you borrow money with a fixed interest rate, the interest percentage is determined by the current market rate. This rate doesn't change over the life of the loan.
Fixed-rate loans may help make budgeting easier because you'll know what your payments are over the life of the loan. With the possible exception of a prorated first payment or a partial last payment (for whatever amount is left on the balance), each month's payment is a predictable amount. For a business taking out a loan over the course of many years or even decades, this predictability may help with long-term cost control. However, if interest rates fall, your loan rate will not change.
Advantages of fixed-rate loans may include:
- Consistent monthly payments that may help financial forecasting.
- Protection from rising interest rates during inflationary periods.
- More straightforward budgeting for businesses with steady income.
Disadvantages may include:
- No benefits from falling interest rates because of market changes.
- Possible higher initial rates than variable options.
- Limited flexibility to adjust without refinancing.
- Potential prepayment fees if loan is paid off prior to stated maturity.
What is a Variable Interest Rate?
A variable interest rate, sometimes called a floating rate, increases and decreases based on an underlying benchmark. Common benchmarks include the Wall Street Journal prime rate; and the Secured Overnight Financing Rate (SOFR).
Lenders may typically combine one of these benchmarks with a margin to determine your interest rate. For example, the interest rate might be calculated based on the prime rate plus 2%. Loan interest may update as often as daily or on a fixed schedule, such as every 30 days, based on the terms of the agreement.
Advantages of variable-rate loans include:
- Potential for lower interest costs if market rates decline.
- May start with a lower rate than a comparable fixed loan.
- Greater flexibility for short-term borrowing needs.
Disadvantages include:
- Monthly payments may fluctuate, making budgeting harder.
- Potential for total interest costs to increase.
- Requires closer monitoring of market trends.
Side-by-Side Illustration: Real-World Repayment Scenarios
Let's look at this difference with a hypothetical example. Imagine a business needs to borrow $100,000. The business owner wants to take out a five-year loan and has the choice of fixed or variable rates.
If the business chooses a fixed-rate loan at the (again, hypothetical) current market rate of 8%, the monthly payment may be about $2,028 per month and cost roughly $21,680 in total interest over the life of the loan. This creates a steady repayment schedule for consistent monthly budgeting.
Now imagine that in this scenario, market rates fall to 6%. The business may be locked into a higher rate unless it chooses to refinance the loan. If the owner had chosen a variable-rate loan, costs would fall to around $1,930, reducing total interest to about $19,800 (assuming rates remain at 6% for the life of the loan).
In the opposite scenario, imagine interest rates instead rise to 9%. The fixed loan is unaffected, while a variable interest loan payment would increase to about $2,075. This would also increase the amount of interest over the life of the loan (assuming rates do not fall below 9% during remaining term of loan).
Assess Pros and Cons Based on Personal Financial Goals
Choosing the right loan depends more on your business's goals, risk profile, and future plans than it does on correctly predicting the market ahead of time.
Who Might Choose a Fixed Rate?
A fixed rate may be helpful for businesses that want to know exactly how much the monthly payment will be over the course of the loan and don't have time to continually check on how the market is performing. Businesses with tighter margins, for example, may be able to plug fixed payments into a budget and forecast costs with fewer surprises.
Additionally, long-term loans may have more time to be affected by market volatility. A 30-year loan must weather changing market rates over the course of three decades, but a 5-year loan may not see as much change without a significant event to disrupt the market.
Who Might Prefer a Variable Rate?
Variable-rate loans might appeal to more well-established businesses with better budget flexibility and bigger cash reserves to weather volatility. If interest rates are currently high, they may also allow you to take advantage of later falling rates.
If a business expects to pay off a loan more quickly, rather than at a steady pace over time, variable rates could offer better initial rates, as well. Companies with resources to research and track market conditions and forecast where markets are heading may also be better equipped to take advantage of variable loans.
Analyze Key Decision Factors: Timing, Term, and Market
We've mentioned several times now about companies analyzing the market as part of their loan decision, but how do they actually do that?
How Do Market Conditions Affect Each Rate Type?
The movement of interest rates is largely determined by economic factors like inflation, central bank decisions, and credit demand. For example, the Federal Reserve may lower interest rates during times of economic recession to help stimulate borrowing and investment. Likewise, when inflation rises, the Federal Reserve may increase interest rates to help slow down spending and borrowing to bring prices back under control.
When looking at market conditions, understanding expectations about the strength of the economy and inflation rates may help you determine which loan is the best fit. A thriving economy with low inflation may feature good interest rates that businesses would want to lock in over a longer term. If all signs point to rising inflation, a fixed-interest loan may protect against volatility.
However, if signs point to the economy slowing, interest rates may start falling alongside inflation. A variable-rate loan may allow you to take advantage of that trajectory.
Should You Fix for 2 Years or 5 Years?
Shorter-term fixed loans sometimes have lower interest rates than longer ones because lenders face less uncertainty in market changes. If you have the capital to make payments on a fixed-rate loan for two years, this may work to your advantage.
The ideal timeline depends on your business's current profile and goals. If you anticipate major changes, such as a shorter-term loan or even a variable one, it might make more sense.
Understand Common Questions and Misconceptions
Several common questions come up as businesses navigate the loan space. Let's answer them.
What is better, a variable or a fixed interest rate?
There is no one answer to this question. The right loan type often depends on your business's goals, unique profile (including risk tolerance), and current circumstances.
What are the disadvantages of a fixed interest rate?
You won't benefit if market rates decline, and you may pay more initially compared to variable-rate loans.
Can I switch from a variable rate to a fixed rate?
In some cases, yes. Some lenders offer opportunities to refinance or lock in a rate, but timing and fees may apply.
Do variable rates ever go down?
Yes, variable rates may decrease in times of market slowdown or stagnation when central banks lower interest rates to stimulate growth.
Choosing a Loan That Makes Sense
Fixed and variable rate loans both serve vital yet slightly different purposes in business funding. Your choice is a personal one, involving a realistic assessment of your current and anticipated future situation. Before you decide, evaluate your financial goals, market outlook, and repayment timeline to determine which rate structure may best support your next stage of growth.
