July 12, 2022 | Last Updated on: January 8, 2024
DISCLAIMER: This article was written in 2022. For updated information on this subject, please go to Which type of small business funding do you need? A guide to funding types
After the low interest rates of the past few years, many potential borrowers have been shocked to find interest rates 3-4% higher than we were seeing at the beginning of the year. As interest rates begin to rise, you may be wondering what the best loan options are for your business needs.
There are a few things to consider when making this decision.
First, think about the purpose of the loan. Is the loan needed to buffer working capital or to make a downpayment on a major purchase? Or maybe to support payroll during a slow period? Or do you need a commercial real estate loan? The type of loan you choose will be based in part on its intended use, the loan amount you need, and the type of business you have.
Second, consider the interest rate environment. If rates are expected to continue to rise, a fixed-rate loan may be your best option. With a fixed-rate loan, your interest rate will remain the same for the life of the loan, so you’ll know exactly how much your monthly payments will be. However, you may end up paying more in interest if rates fall after you take out the loan (of course, you can always refinance).
If you expect interest rates to stabilize or even decline, variable-rate business financing may be the better choice. With variable rate financing, your interest rate will fluctuate along with market rates. This means that you could end up paying more in interest over time, but it also means that your payments could go down if rates fall. Just remember that no one can predict the future, and rates are just as likely to go up as they are to go down, so if you’re considering variable financing, make sure that your decision makes sense even if rates go up.
Finally, think about your repayment timeline. An adjustable rate loan may be the best option if you need the flexibility to make lower payments at first and then ramp up as your business grows. With an adjustable-rate loan, your payments will start out low and then increase at set intervals over the life of the loan.
No matter what type of financing you choose, be sure to shop around and compare rates and terms from multiple financial institutions before making a decision. Always make sure you understand the terms and conditions included by your lender before signing on the dotted line.
Several loan programs are available to small businesses, depending on how you intend to use the funds.
Equipment loans are meant to finance large purchases of equipment. The loan terms range from five to seven years and usually have fixed interest rates throughout the life of the loan. The interest rate on the loan will depend on the type of equipment, your equipment financing needs, length of the repayment period, and your credit score.
Working capital loans are meant to create a cash buffer for business operations. They may be secured or unsecured. The interest rate on the loan will depend on either your personal or business credit score (or both). If your business is a startup, you’ll need to have a strong personal credit score to obtain a loan. Because they are not secured by specific assets, the interest rates tend to be higher than other types of loans. These loans may be variable or fixed interest rate loans. Many working capital loans from online lenders can be obtained in a single business day, which is significantly faster than traditional bank loans.
Instead of taking a large loan out for potential future business needs, you can set up a business line of credit. Business lines of credit allow you to draw funds for a certain number of years followed by a repayment term (usually 7-10 years). During the draw period, the payments are usually interest only, keeping your payment low, but making your entire balance subject to varying interest rates. While you can draw the entire amount of your line of credit in a lump sum upfront, you don’t have to, and you only pay interest on the amount you use, just like with a credit card. Lines of credit have variable interest rates so they may not be the best choice in a rising interest rate environment. But if you have a low balance in your bank account, it may be helpful to have a line of credit open with a decent amount of money available.
If you’re running a business, you should also consider opening up a business credit card for expenses. This is especially true for new businesses that may find that they are too young to be qualifying for financing because they lack the minimum credit score and business history. Always paying off your credit card is a good way to build creditworthiness. However, you probably don’t want to carry interest on it for very long due to the high interest rates.
A variable interest rate loan is a type of loan where the interest rate can change over time. This means that your monthly repayments can go up or down, depending on how the interest rate changes.
Variable interest rate loans are usually linked to the prime rate, so if the cash rate goes up, so does your interest rate. Variable interest rates can be good for borrowers because they sometimes go down as well as up – giving you the opportunity to make extra repayments and pay off your loan faster.
But they can also be risky because if rates go up, your repayments could become unaffordable. That’s why it’s important to understand how variable interest rate loans work before you decide if one is right for you.
Your loan terms will outline how often the rate on the loan can change and usually include maximum adjustment amounts. For example, a loan may state that the rate will be updated annually and cannot increase more than 2% in a single year. The terms can vary by lender so it is crucial that you understand how your rate may adjust.
When you’re shopping for a loan, it may be helpful to think about financing in two categories: fixed-rate or variable-rate. Fixed-rate loans offer predictability because your interest rate will stay the same for the life of the loan. That means your monthly payments will also stay the same, making it easier to budget. Variable-rate loans, on the other hand, often start with a lower interest rate than fixed-rate loans. But that rate can change over time, depending on market conditions.
When you’re taking out a loan, it’s important to consider loan term length. A longer-term will mean lower monthly payments, but it will also mean that you’ll end up paying more in interest over the life of the loan. Short-term loans will mean higher monthly payments, but you’ll pay less in interest overall.
Ultimately, the right loan term for you will depend on your financial goals and priorities. If you need to lower your monthly payments in order to free up some cash flow, a longer loan term may be the way to go. On the other hand, if you want to pay off your loan as quickly as possible, a shorter term may be the better option. Talk to your lender about your options and choose the loan term that makes the most sense for you.
When you purchase a mortgage on your home, you’ll pay off the entire loan balance over the life of the loan. Commercial loans are often structured differently and include a balloon payment at the end of the loan term.
For example, a commercial loan might be a 10-year term amortized over 25 years. On this loan, the payments will be calculated as though you were going to pay off the loan over 25 years, but you’ll make those payments for 10 years with the remaining balance due at the end of year 10.
When a commercial loan includes a balloon payment at the end of the loan, the intent is to have paid off the loan entirely by the end or to refinance. However, in a rising interest rate environment, a refinance may not be affordable and interest rates may continue to rise making a new loan at the end of the payment term an unattractive option.
If you need to secure financing despite today’s rising interest rates, you’ll probably be on the lookout for better loan options in the future. You need to consider whether the initial loan you are taking out comes with any prepayment penalties.
One of the most attractive loan options for small businesses is a U.S. Small Business Administration (SBA) loan. The SBA backs loans for small businesses, allowing them to get loans at a lower interest rate (often the lowest interest rate available) if they qualify. SBA loans are made through various lending institutions but have stringent eligibility guidelines which lead to long loan application processes and rigorous underwriting requirements. You’ll typically need a business plan, bank statements, and tax returns with your annual revenue in order to apply, and these loans carry substantial prepayment penalties. The prepayment penalty in the 1st year is 5% of the outstanding balance, in the second year it’s 3%, and in the 3rd year, it’s 1%. These types of prepayment penalties can offset any savings achieved by refinancing your loan unless you can secure a significant drop in interest rate. The SBA backs several loan products, but the most popular is the SBA 7 loan.
One of the factors that will be taken into account when looking for financing is how you are going to use the funds. Loans that are used for real estate purchases or equipment purchases often carry lower annual percentage rates because they are secured by capital assets.
If you are not using the funds for a capital purchase, you can pledge unrelated assets to secure the loan and lower your interest rate. For example, some lenders will accept a personal guarantee like a lien on your primary residence for a small business loan even though your primary residence is not a business asset. This provides the lender with protection in the unlikely event that you default on your loan.
Ultimately, the right type of financing for your business in a rising interest rate environment will depend on your time horizon, the purpose of the loan, and business cash flow.
If you expect interest rates to decrease in the future, variable interest rate financing will take advantage of future decreases in interest rate, but there is always the risk that interest rates will remain high or increase in the future. Pursuing variable interest rate financing will depend on your tolerance for risk, and the type of financing you need.
Taking out a fixed-rate loan in a rising interest rate environment can lock in fixed payments, and you come out ahead if there are higher interest rates in the future. However, you risk decreasing interest rates in the future, and you are stuck with your current interest rate. You may be able to refinance in the future to get the lowest rate, but you might be subject to prepayment penalties, and if the value of your assets decreases, you may not have the equity needed to refinance your loan.
There are many different types of loans available, and it can be challenging to choose the one that is right for you. However, by taking the time to understand your options, you can find a loan that best suits your needs.
If you’re overwhelmed by the number of options for business loans and aren’t sure how to navigate the lending process at traditional banks and credit unions, working with a loan broker can relieve the stress and make the lending process more efficient. Loan brokers have considerable experience working with small business owners and helping them evaluate their financing options. At Biz2Credit, the business lending professionals have helped thousands of owners and entrepreneurs obtain the financing they need, such as The Party Staff Inc., who obtained a working capital loan quickly to keep their business afloat through the pandemic.
