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- Variable vs Fixed Rate Loans – What’s the Difference?
Access to low-cost capital is more important than ever for America’s small business owners. If you’ve been researching ways to fund your business, it’s likely that you already have a checklist of important factors to consider. It’s also important to consider finding a lender who is completely transparent, who can help determine details like what the fees will be, amount of money you can borrow, and how long the loan term is going to be.
Finally, determine if the annual percentage rate (APR) is fixed or variable. Here’s some information about both Fixed Rate Loans and Variable Rate Loans to help you make an informed decision.
Terms to know
When seeking a loan, you might come across terms you are unfamiliar with. Here are a few common terms you might see in a loan agreement:
- Interest: The amount of extra money your small business will pay back to the lender in addition to what you borrowed. The interest rate is a percentage of the amount you borrow.
- Compounding: Interest is charged on both the amount you originally borrowed, and any interest already accrued on that amount, less any repayments you have made. This is known as compound interest.
- Loan duration: The amount of time agreed upon to pay back the loan. The duration of a loan typically runs from three to five years, although it may be longer or shorter.
- Repayment: The monthly repayment you make to reduce the balance of your loan.
- Base interest rate: The interest rate set by the government upon which loan and savings rates are based.
For additional terms important to small business owners, visit the SmartBiz Small Business Blog: Glossary of Terms for Small Business Owners.
What is a variable rate loan?
Variable rate loans are loans with an interest rate that will fluctuate over time in line with established interest rates. They generally have lower starting interest rates than fixed rate loans, but the interest rate and payment amounts can raise or lower over time. SmartBiz offers a variable rate on SBA 7(a) loans.
Examples of variable rate loans include:
- Credit cards. Some credit cards come with interest rates that change over time in accordance with the economy’s index rate. Note that your credit card issuer doesn’t need to notify you when these rates change.
- Mortgages. Adjustable-rate mortgages (ARMs) start below the market rate for similar loans. At first, this rate remains constant, but over the life of the loan, it typically grows at a predetermined frequency.
- Government loans. Some government loans, including SBA 7(a) loans, may have different rates depending on their loan size. These rates often change with time.
How variable rate loans work
Typically, variable interest rates fluctuate based on some sort of benchmark figure. In the U.S., the most common such benchmark is the prime rate. This rate is innately connected to the Federal Reserve funds rate, which the government controls. Lenders can profit when they charge borrowers a margin or spread atop the prime rate.
What are the current SBA loan variable rates?
Here are the current rates for an SBA loan through banks in the SmartBiz network:
9% - 10%
Why does the Prime Rate fluctuate?
The Prime Rate generally changes sporadically. It may stay the same for years, but it may change several times within a single year. The Prime Rate is determined by meetings of the Federal Open Market Committee of the Federal Reserve Board.
The Prime Rate tends to rise when the economy is growing too quickly and inflation (the increase in the overall cost of goods and services over time and the reduction in the value of money) is going up faster than intended. The Prime Rate tends to fall when the economy is weaker, when financial markets are under pressure, and the government wants to stimulate growth. The Prime Rate tends to stay the same when the economy is growing at a reasonable pace and there is low, manageable inflation.
Definition of a variable rate loan
A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest rates change. The interest charged on a variable interest rate loan is linked to an underlying benchmark or index, such as the Prime Rate.
Advantages of a variable rate loan
When considering loan types, look at how you might benefit from a variable rate loan. The advantages of your interest rates rising with time typically manifest in the short, not long, term. They include:
- The overall cost of variable rate loans is usually lower than a fixed rate loan. Though seemingly counterintuitive, this notion may be true because your initial rate may be so low it counterbalances higher rates down the line.
- Variable rate loans tend to have more competitive interest rates than fixed rate loans. The initial interest rate on your loan may be quite low, so the lender can better hide the higher rates that emerge later.
- If the base rate goes down, it’s likely your lender will reduce the rate on your small business loan, meaning your total amount payable, and your monthly payments, will reduce.
Disadvantages of a variable rate loan
Consider some of the below disadvantages of a variable rate business loan. These drawbacks pertain primarily to the prime rate – and thus your loan’s interest rate – increasing. Such increases do happen, as inflation, which has been consistent in previous decades, increases the prime rate. However, future decreases in the prime rate aren’t wholly infeasible, and these shifts would counter the below drawbacks.
- If the interest rates go up, your small business lender’s interest rate will go up as well. This means your total amount repayable and your small business’s monthly payments will increase.
- If the interest rates go up, this could impact your budgeting and operational expenses, especially if you have a tight cash flow.
What is a fixed rate loan?
Fixed rate small business loans have an interest rate that does not change during the life of a loan, which means you generally pay the same amount each month. With a fixed rate loan, the interest you owe per month would only change if you refinance your loan. In that case, you’d pay less interest if your monthly payments become smaller, and more interest if your payments become bigger. But the actual interest rate will remain the same.
Examples of fixed rate loans include:
- Personal loans. Many personal loans will charge you the same interest rate no matter how long it’s been since you first took out the loan. These fixed interest rates may vary depending on your loan issuer, but each provider’s rate should remain constant with time.
- Auto loans. As with many types of loans, auto loans can come in fixed and variable rate varieties. Fixed rate auto loans may be slightly more common, and they lead to predictable monthly interest debts alongside your standard car payments.
- Private business loans. Some private business loan rates are constant and independent of changes in the prime rate. Rarely will two private lenders offer the same fixed rate. Plus, variable rate government loans may – as you’ll see below – be better for your business.
Advantages of a fixed rate loan
With a fixed rate loan, you won’t get any surprises. You’ll always know exactly how much interest you owe with each of your payments. Just multiply your payment amount by your interest rate to determine your debt. Even if your payments vary in size, this interest calculation remains quick and simple. Some more advantages include:
- If the prime rate rises, it won’t impact the overall cost of your loan.
- Fixed rates mean you can manage your cash flow accurately to protect your business.
- You will know exactly the total interest that you’ll pay over the life of the loan.
Disadvantages of a fixed rate loan
A fixed rate might not be for you based on some of the following reasons. The first reason isn’t super likely (but isn’t impossible either) given that inflation, and thus the prime rate, typically increases with time. The second may seem counterintuitive but is indeed the prevalent trend when you compare and contrast fixed and variable rate loans. The third reason is perhaps the most straightforward.
- If the base interest rate goes down, you don’t get the benefits of the reduced rate. Instead, you’ll continue to pay the fixed rate.
- Fixed rate loans for small businesses tend to have higher interest rates than variable rate loans.
- Since fixed rate loans present a potential loss for lenders if the prime rate increases, lenders may require higher credit scores to qualify for them.
Choosing between a fixed and variable rate loan
When weighing variable versus fixed rate loans for your small business, weighing a handful of factors can help you come to the right decision. These factors may look different for every loan and every business. Take your time assessing your situation and loan options, and you should be on your way to making the right choice. Some factors to note are:
- Potential future interest rates. Let’s say you expect the prime rate to rise over time – a reasonable assumption given the nature of inflation. For shorter-term loans, you may prefer a fixed rate loan. However, for longer-term loans, variable rates may prove better. That’s because, as discussed earlier, they often wind up less expensive over time.
- Loan length. When seeking shorter-term loans, fixed rate loans may prove more reasonable. After all, experiencing a rate shift just two months into a three-month loan may feel jarring. In the long term, though, variable rates often prove more affordable.
- Current fixed versus variable rates. In lending, the term “spread” is sometimes used to describe the difference between the lowest available fixed rate and lowest available variable rate. You might fare better with a variable rate during times of high spread.
- Risk tolerance. If the notion of having to pay more interest later on sounds risky, you may fare better with fixed rate loans. However, taking out variable rate loans may help you fund business ventures that bring in enough income to cover loans of any size. And since variable rate loans are often less expensive in the long run, they may ultimately be less risky.
Questions to ask your lender
Make sure you’re working with a trustworthy lender, one that has a track record of successful fundings, with stellar customer service. Some additional questions to consider are:
- Is there an initiation fee for getting the loan that’s charged before you get the money?
- What is the interest rate for the loan and how is it applied?
- What are the repayment terms for the loan?
- What is the monthly repayment amount?
- What will be the total amount that’s repayable?
- Do you need to provide any guarantee or collateral for the loan?
- Can you repay the loan early?
- Are there any other fees?
- Are there any special terms and conditions?
The bottom line
Review the entire loan package and determine the best fit to strengthen your finances, and seek out a lender with stellar customer service. You’ll want to work with a knowledgeable loan specialist who can clearly and thoroughly answer all of your questions.
WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.