Interest rates are crucial for small business owners to understand, especially those who borrow money via business loans or lines of credit, as well as those who earn interest on their business checking account. With rates frequently fluctuating, it’s also important to know why changes might occur.
Let’s explore what different types of interest rates are, and what may cause changes over time.
What is an interest rate?
An interest rate is the amount you have to pay to borrow money, and it’s calculated as a percentage of the principal amount. For example, if you borrow $100,000 at 5% interest, then you’ll need to repay $105,000 in total.
Interest rates may vary from under 5% to over 20% depending on your lending profile, the style of financing you select, and the national rate set by the Federal Reserve (more on this below).
However, interest rates can also work in your favor. When you deposit your money into a business bank account, as opposed to borrowing, you can earn interest on your balance.
It’s a common misconception that only business savings accounts will generate a return. But the best business checking accounts will let you earn interest on your operating balances––saving you the trouble of transferring money back and forth between accounts.
What’s the difference between APR and APY?
The annual percentage rate (APR) is the yearly interest that you will pay for any sum that you borrow. On the other hand, the annual percentage yield (APY) is the yearly interest that you will earn on any interest-bearing accounts.
The most common use of an APR is when you borrow money with a loan. For example, if you take out a $10,000 business loan with 5% APR, then you will be required to pay 5% interest on the outstanding principal until the loan is repaid.
On the other hand, the most common use of APY is when you open a business checking account that earns interest. For example, if you deposit $10,000 into a high-yield checking account that generates 2.0% APY, then you will earn 2.0% on your balance. Of course, interest rates are in a constant state of flux and earned interest is typically paid out on a monthly basis, depending on how your bank calculates interest.
What causes interest rates to rise and fall?
Interest rates are influenced by a number of different factors, including inflation, economic activity, and the national rates set by the Federal Reserve, known as the federal funds rate.
The Federal Reserve adjusts interest rates to either encourage or discourage economic activity. It does this by adjusting the federal funds rate, which is the rate that banks charge for short-term loans. This national rate is what affects interest rates and trickles down to impact other forms of credit like credit cards, mortgages, business checking accounts, etc.
In general, the Federal Reserve lowers interest rates to encourage borrowing and stimulate the economy. However, too much borrowing is risky, can lead to inflation, and can encourage people to make speculative investments. If the economy starts to grow too quickly, the Fed will raise interest rates to discourage borrowing and slow economic activity.
With this in mind, interest rates are always changing depending on the actions of the Federal Reserve and the economy at large. In periods of high inflation and interest rates, businesses need to be extra cautious to ensure they are making good use of their finances.
What should I do when interest rates change?
When interest rates are higher, it means that borrowing and the cost of debt are more expensive. For this reason, it makes sense for business owners to pay down existing debt and limit the amount they borrow. However, since rates are higher, it’s also a good idea to take advantage of high-yield business checking accounts.
When interest rates are lower, it means that borrowing and the cost of debt are more affordable. During these cycles, it’s a good idea to apply for a line of credit if you think it can help grow your business.
Now that you know a little bit more about what affects interest rates, you can do your best to anticipate these changes.
How do business loan interest rates work?
Business loan interest rates work a lot like traditional interest rates. In other words, you need to apply for funding and the lender will evaluate your business’ financial situation to review your application, as well as determine the terms of your loan. For business loans, lenders will typically look at factors like your business and/or personal credit score, business income, and the length of time you’ve been in business.
The process is similar for a business line of credit, which offers a revolving line of funding like a credit card. As your business repays the money it borrowed from your credit line along with the interest owed, the credit is replaced and becomes available again.