Fixed Rate Loans vs. Variable Rate Loans – What’s the Difference?

In 2021, 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, you should have a checklist of important factors to consider. Find a lender who is completely transparent and 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 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.

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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. This is shown as an interest rate.
  • Compounding: Interest is charged on both the amount you originally borrowed, and any interest already accrued on that amount, less 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 can 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 that loan and savings rates are based on.

Definition of a variable rate loan

Investopedia® defines variable rate loans as 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.

Here are the current rates for an SBA loan through banks in the SmartBiz network (as of October 2021):

Interest Rates 

4.75% - 7.00%*

*SBA loans offered from banks in the SmartBiz lending network have a variable rate of Prime Rate plus 1.5% to 3.75%.

Why does the Prime Rate fluctuate? 

The Prime Rate generally changes infrequently. It may not change for years, but, in some years, it has also changed several times. 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, including:

  • The overall cost of variable rate loans is usually lower than a fixed rate loan.
  • Variable rate loans tend to have more competitive interest rates than fixed rate loans.
  • 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 these disadvantages of a variable rate business loan:

  • 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 overall operations.
  • If the interest rates go up, this could impact your budgeting and operational expenses, especially if you have a tight cash flow.

Definition of 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.

Advantages of a fixed rate loan

With a fixed rate loan, you won’t get any surprises. Some more advantages include:

  • If the interest 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:

  • 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.

Questions to ask your lender

Make sure you’re working with a trustworthy lender withs 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.