4 Critical Ways Interest Rates Affect Small Businesses
Business planning is tough, especially as a small business owner who often is the head of HR, the accountant, and the marketing guru all at the same time. When economic changes, like interest rate hikes, occur it’s up to you to handle them.
This article will discuss how interest rate hikes affect small businesses. Then we’ll look at how to calculate interest rates and what they’ll cost you. Finally, we’ll wrap up with some tips on how to handle interest rate hikes.
The Fed funds rate increase explained
On June 15th, 2022, the Federal Reserve (“the Fed”) raised interest rates by 0.75 of a percentage point. This rate hike is the largest since 1994, and it’s also the third rate hike this year.
Rate hikes, like the June 15th hike, are often aimed at countering inflation. This year, Americans experienced the fastest pace of inflation in over 40 years. The annualized rate of inflation at the time the Fed hiked interest rates was 8.6%.
One of the most powerful ways to combat inflation is to raise interest rates, which helps slow down the availability of cash to be lent out. Typically, these interest rate hikes are done when the economy is performing well.
Although many experts and financial institutions claim that the market is not entering a recession, huge layoffs in the tech industry, out-of-control inflation, high market losses, and housing market volume drops seem to suggest otherwise.
In any case, the goal of the Fed is to stabilize inflation and execute a “soft landing,” that is, slow inflation without causing a recession. The Fed is likely to raise interest rates by 3.5% by the end of 2022 and 4% by the end of 2023. Historically, when the Fed has raised rates quickly, an economic downturn has been unavoidable.
How interest rates affect small businesses
Besides a recession, interest rate hikes can affect small businesses and consumers in many ways. In this next section, we’ll look at the impacts that interest rate hikes can have on businesses and consumers and how those changes can impact your company too.
1. More expensive business loans
One result of interest rate hikes is that business loans will get more expensive and potentially lead to increasingly strict eligibility requirements.
The Federal Reserve Bank (the central bank of the United States) is responsible for managing the total supply of U.S. dollars and substitutes. It doesn’t mean the Fed literally prints money off a machine, but it does enact policies that impact the amount of money in circulation.
The Fed’s interest rate is used as the benchmark for borrowing costs that individual banks set. The Fed has several other policies at its disposal that can impact how much money banks hold, but interest rate hikes primarily impact how banks establish their own benchmarks. Most businesses have some form of business banking, so rate hikes will ultimately impact everyone.
2. Credit card rates increase
Similar to loan rates increasing for businesses, credit card rates can also go up for similar reasons. Credit card companies often rely on the Fed to determine where to set their benchmarks for interest rates. As interest rates increase, credit card rates for your business card and consumer credit cards may see an increase as well.
3. Market participation tends to slow down
When rate hikes occur, participation in markets tends to decrease.
Inflation can be caused in any number of ways, but typically high demand (led by supply chain issues today), wage increases, and expansionary fiscal policies can all lead to inflation.
The rate hike specifically reduces inflation by helping lower product demand by limiting the available cash in supply. As a result, market participation is often a collateral victim of these policies.
Reduced available cash means less investing, less purchasing, and a slower-moving economy. In the end, this can help inflation, but it can also be disastrous if too much is done too soon.
4. Decreases customer buying power
Since current interest rates are higher, consumers have lower buying power.
When interest rates go up, consumer debt costs increase as well. It can cause consumer debt to swell overall, which means you’ll be paying more interest on your credit bills. When consumers face higher costs on their credit, loans, and other debt-based instruments, their spending decreases.
Decreasing consumer buying power helps limit inflation, but unfortunately, consumer buying power is collateral damage when it comes to overcoming inflation.
How quickly will the interest rate increase affect small businesses?
Now that you know how interest rate hikes can affect small businesses, you’re probably wondering how soon you’ll see an impact. Some effects can be immediate; others, like credit card interest rates, can take several billing cycles to become visible.
One almost immediate impact will surely be lower consumer spending. Consumers have already been hit hard by inflation, and interest rate hikes will decrease their spending further.
How to calculate your interest rate impact
If you noticed your interest rate increased recently, or if you want to know what your costs are, you can calculate how much the rate hike impacts your payments with a simple compound interest formula:
A = P*(1+r/n) n*t
- A = Total (future) balance owed
- P = Principle (the loan or credit amount)
- r = interest rate (in decimal)
- n = the number of times interest gets compounded per period
- t = how long the money is invested for (the number of periods)
Example: You get a small business loan for $10,000 to install some new equipment. The bank charges you an interest rate of 5%, compounded yearly, for 10 years. Let’s calculate how much you’ll owe, including interest and the principle:
A = $10,000 x (1 + .05 / 1) ^ (1 x 10)
A = $16,288.95
Wow! As you can see, compound interest can add up quickly. When rates get hiked and your interest rates go up, you can see how much faster your money gets eaten up by interest. Play around with the interest rate and watch how much higher the total amount owed is. Increasing the interest rate by just 1% (to 6%) changes the total to $17,908.47!
A good way to understand this type of exponential growth is to view it as a table.
|Year||Interest Calculation||Interest Earned||End Balance|
|Year 1||$10,000 x 5%||$500||$10,500|
|Year 2||$10,500 x 5%||$525||$11,025|
|Year 3||$11,025 x 5%||$551.25||$11,576.25|
|Year 4||$11,576.25 x 5%||$578.81||$12,155.06|
|Year 5||$12,155.06 x 5%||$607.75||$12,762.82|
|Year 6||$12,762.82 x 5%||$638.14||$13,400.96|
|Year 7||$13,400.96 x 5%||$670.05||$14,071|
|Year 8||$14,071 x 5%||$703.55||$14,774.55|
|Year 9||$14,774.55 x 5%||$738.73||$15,513.28|
|Year 10||$15,513.28 x 5%||$775.66||$16,288.95|
As you can see, the reason compound interest is so powerful is because it builds on each previous balance.
How to minimize the impact of increased interest rates
Now that you know just how powerful interest rates can be, let’s examine how your business can minimize the costs and impact associated with rising interest rates. Understanding ways to minimize the impact of interest rate hikes can help your business plan ahead and avoid some of the costs associated with the Fed putting the squeeze on inflation and the economy.
1. Review your current financial statements
The best place to start when trying to minimize the impact of increasing small business loan interest rates is to review your current financial statements. Even if you’re not an accountant or don’t have any experience in accounting, financial statements can reveal a lot about your business.
You should endeavor to have a comprehensive understanding of your financial statements because it will enable you to see where your money is coming from, where it’s being spent, and help you identify problems related to your business’ finances. For example, reviewing your financial statements can tell you whether you’re spending too much on web hosting every year.
2. Develop forecast scenarios
Next, consider developing forecast scenarios. Forecasting is essential in a business to predict how much cash flow you’ll have or how much product you need to order. Forecasting, using statistical models, can further develop your ability to predict and plan.
For example, when properly utilized, a forecasting model can tell you the correct mix of products to maximize your profitability. These prediction tools for maximizing profits and minimizing expenses are crucial when the Fed raises interest rates. In addition, these tools will also make your business more effective in general and can even help you weather a recession.
3. Identify debt to focus on
Both steps above can be key for identifying debt to focus on. The amount of debt you carry is often directly related to the interest rate for that debt. When you take out loans with variable rate interest rates, your debt will go up when interest rates are increased.
Identifying significant areas of debt can help you figure out which loans or credit cards to pay down first. Attacking these bills can help minimize the dangers of paying excessive interest.
4. Focus on improving cash flow
It may seem obvious, but cash flow is one of the key metrics for businesses, especially small businesses with less working capital than larger companies. Cash flow can be critical in industries like the rental market, which rely on regular rent payments to arrive every month. Business owners should find ways to improve cash flow to help bolster against interest rate increases.
For example, reducing the time it takes to collect your receivables can be a simple way to improve cash flow. Improving cash flow doesn’t have to just mean increasing it. Accepting alternative payment methods and finding better tools for invoicing can all be beneficial to your business. According to a recent study by GetWeave, veterinarian offices that switched to a business VOIP phone system were able to save $300 a month on phone bills!
5. Explore refinancing options and credit score improvements
If you have outstanding debt, whether subject to interest rate hikes or not, exploring refinancing options and improving your credit score are great ways to strengthen your business. Refinancing can lower your interest rate and help reduce your monthly payments. Additionally, interest rates aren’t the only thing that determines how much you pay—your credit score, among other things, can also have a huge impact on the cost of debt.
6. Create a recession plan
Finally, create a plan for if a recession occurs. Interest rate hikes don’t always lead to a recession, but economic signs certainly point towards one. Developing a strategy for fighting recession can help you plan your approach to dealing with interest rate hikes and how to approach the problem in the future. Your business should have contingency plans, including a recession plan, so you aren’t caught off guard.
Understand how interest rates impact your business
Understanding interest rate hikes and how they impact your business is crucial for small business owners. When you understand interest rates and can calculate how much you’ll end up paying because of them, your small business will be much better off. If you follow these tips, your small business will be sure to handle anything the economy (or a customer) might throw at you.
Looking for a tool that can help you explore the effects of interest rates rising, taking on funding, or diminished sales? With LivePlan’s advanced forecasting and financial reporting features, ongoing planning, and performance reviews are quick, easy, and insightful. Determine if you can handle a rate increase, if you’ll have enough cash on hand, and what you need to adjust in the face of shifting customer interests.