Should You Worry About Rising Loan Rates?

SmartBiz offers 10 year variable rate SBA guaranteed 7A loans. The interest rate on these loans is variable, meaning it can rise and fall with market interest rates, specifically with movements in the “prime rate ”. If the prime rate increases, monthly payments on loans with rise as well. Conversely, if the prime rate goes down, loan payments will fall. While there are strong reasons to believe that rates will rise over the next 10 years, such a rise is likely to be modest, and should not be a major concern for those seeking to take an SBA guaranteed loan.

Before I begin, I should share with you my background. Over 15 years ago, I started my career on Wall Street as a currency market analyst. More recently, I served as publisher of the website Learn Bonds, which provides education on investing in CDs and bonds. Today, I am publisher of Fit Small Business, which provides “how to” advice to small business owners, and is a business partner of SmartBiz. My combination of having a background in finance and small business gives me a unique perspective to comment on the topic of rising interest rates and variable rate SBA guaranteed loans.

What is prime rate?

Technically, prime rate is the base interest rate which banks charge their corporate clients on loans before adjusting for risk and loan duration. However, when most people refer to the prime rate they are really talking about the Wall Street Journal’s prime rate index, which tracks the prime rate at the 30 largest lending institutions in the United States. Historically, the prime rate has moved in tandem with other short-term interest measures like LIBOR and the Fed Funds Rate. The prime rate is generally about 3% higher than LIBOR.

Between 2004 and 2014, the prime rate has been between 3.25% and 8.3%. However, for the last few years, the prime rate has been at the very bottom of the range.

WIll the prime rate rise?

Over the next 2 years, most economists expect the prime rate to rise. Following the housing market collapse in 2007, the Federal Reserve took unprecedented steps to keep interest rates low, including buying bonds, and lowering the discount rate (the rate at which banks can borrow money from the Fed) to a hair above zero. As the Federal Reserve stops buying bonds and raises its interest rates, general interest rates, including the prime rate, are expected to rise.

However, the Federal Reserve is not the sole determinant of interest rates. As the Federal Reserve stops taking as an aggressive a role, market forces will have more impact on rates. Historically, there is a strong relationship between inflation and interest rates. Generally investors want to earn more than the rate of inflation when buying debt. Over the last few years, inflation has been hovering around a very mild 2%. If this continues, it suggests that interest rates will not significantly rise over the next few years.

One of the best indicators of future short-term interest rates is current long-term interest rates. Investors that expect short-term interest rates to rise generally demand more interest when investing for longer periods of time. The yield difference between the 2 year treasury and 10 year treasury currently is less than 2%. This would suggest that investors expect a modest rise in short-term interest rates over the next several years.

Taking in all this information, I think that a reasonable expectation is the prime rate will rise between 2 and 5% over the next 10 years, in a relatively gradual process.

How would this affect the monthly loan payments on a SmartBiz SBA loan? 

Lets take the high end of the estimate above, a 5% increase in the prime rate over 10 years. Would this lead to a 5% increase in the amount of monthly loan payments? The answer is NO! Even if interest rates were to rise by 5%, the chances this would occur overnight are small. A possible scenario that I believe is more likely (assuming a 5% increase interest rates) would be for rates to increase by 1% in the first two years, 2% in the next four years, and 2% in the last four.

While SmartBiz SBA loans are designed to have equal monthly payment amounts, the composition between paying interest and paying down principal changes over time. During the early years of the loan, the payments are almost all interest. Near the end of the term of the loan it has become almost all principal. Because of this, a 2% increase in interest rates will have far less impact on the dollar amount of loan payments at the beginning of the loan than at the end. While a 2% increase in interest rates will increase loan payments by close to 2% if the rise happens in the first year of the loan, the impact will be closer to ¼% if it happens in the last year of the term. Thus, a 5% increase in interest rates over 10 years doesn’t mean a 5% increase in the $ amount of monthly loan payments!

Bottom Line: Loan Payments will probably rise during the course of the loan, however, I expect the rise to be modest. Furthermore, rate increases that happen at the end of the loan will have fare less impact on monthly payments than increases that happen closer to the start date of the loan.

About The AuthorMarc Prosser is the co-founder and publisher of Fit Small Business, where he writes regularly about financial topics such franchise financing. Previously, he served as publisher of Learn Bonds and Chief Marketing Officer of FXCM.