Small Business Loans: Variable vs. Fixed Rates Explained

Understanding Variable-Rate Loans

Variable-rate loans are a type of financing where the interest rate can change over time. These loans are tied to a benchmark rate, often the prime rate set by the Federal Reserve. As market conditions shift, so does your interest rate — and with them, your payments.

Here's how variable-rate loans work: Your loan agreement will specify a margin above the benchmark rate. For example, if the prime rate is 3% and your margin is 2%, your interest rate would be 5%. When the Federal Reserve adjusts the prime rate, your rate changes, too.

The Fed's monetary policy plays a key role, as do overall market rates and economic conditions. Rates tend to rise during economic growth periods, and likewise, they often fall during downturns.

It's important to note that a variable interest rate loan doesn't refer to any single type of loan. There are different kinds to choose from, and they all come with their own terms and conditions. For instance, some might have rate caps, limiting how high your rate can go, while others might adjust monthly or annually.

Pros and Cons of Variable-Rate Loans

Variable-rate loans come with their fair share of advantages and drawbacks. Let's break them down:

Pros

• Lower initial rates. Variable-rate loans tend to start off with lower interest rates than fixed-rate options, which can mean lower initial payments and the cost of borrowing.
• Potential savings. If market rates decrease, you could end up paying less over time.
• Flexibility. Some variable-rate loans offer easier refinancing or prepayment options.

Cons

• Unpredictable payments. Your monthly payments can fluctuate, making budgeting tricky.
• Risk of higher costs. Rate increases can lead to higher interest rates and increased overall borrowing costs.
• Cash flow challenges. Rising rates might strain your business's cash flow if payments increase significantly.

Consider your risk tolerance when weighing these options. If you're comfortable with some uncertainty and believe rates might decrease, a variable-rate loan could save you money. But if you prefer predictability, you might want to look elsewhere.

Refinancing is always an option if your rates change dramatically. However, this comes with its own costs and considerations, so it's not a decision to be made lightly.

Understanding Fixed-Rate Loans

Fixed-rate loans are straightforward: the interest rate remains constant for the life of the loan. Whether you're borrowing for five years or 30, your rate won't budge, regardless of what's happening in the broader economy.

This predictability is the hallmark of fixed-rate loans. Your monthly payments will stay the same through the duration of your loan term, making budgeting and long-term financial planning easier for your business.

How do they work? When you take out a fixed-rate loan, the lender calculates your payments based on the principal, interest rate, and loan term. This amount is then divided up equally across monthly payments for the entire loan period.

It's worth noting that while your payments remain constant, the proportion of interest to principal will fluctuate over time. In the early years, more of each payment goes toward interest. As you progress through the life of the loan, more of each payment goes toward the principal.

Pros and Cons of Fixed-Rate Loans

Fixed-rate loans have their own set of advantages and disadvantages. Let's explore them:

Pros

• Predictable payments. Your monthly payments remain constant, making budgeting easier.
• Protection from rate increases. No matter what happens to market rates, your rate stays the same.
• Peace of mind. You know exactly what your loan will cost over its entire term.

Cons

• Potentially higher initial rates. Fixed rates are often higher than initial variable rates.
• Missing out on rate decreases. If market rates fall, your rate won't change unless you refinance.
• Higher total cost. The predictability of fixed-rate loans often comes at a premium, which may increase the overall cost of borrowing.

When considering fixed-rate loans, think about your business's need for stability versus potential savings. If you value consistency in your monthly payments and want to protect against future rate increases, a fixed-rate loan might be your best bet.

Remember, the total cost of a fixed-rate loan is clear from the outset. This transparency can be valuable for long-term financial planning, even if it means potentially paying more in interest over time compared to a variable-rate loan in a falling-rate environment.

Comparing Variable and Fixed Rates

When it comes to small business loans, the choice between variable and fixed rates can significantly impact your finances. Let's break down the key differences:

Risk

• Variable rates have higher risk due to potential rate increases.
• Fixed rates have lower risk with predictable payments.

Cost

• Variable rates could have lower initial costs, but uncertain long-term expenses.
• Fixed rates often have higher initial rates, but predictable total interest over the loan term.

Loan amount

• Variable rates may allow for larger loan amounts due to lower initial rates.
• Fixed rates might have more conservative loan amounts due to higher initial rates.

Repayment terms

• Variable rates can be more flexible, often with shorter terms.
• Fixed rates typically offer longer terms with consistent payments.

Suitability

• Variable rates can be helpful for short-term needs such as working capital or inventory financing.
• Fixed rates are often preferred for long-term investments such as commercial real estate or equipment purchases.

Credit score considerations

• Variable rates might be more accessible but riskier for those with bad credit.
• Overall, more options are likely available to those with good credit, and that includes competitive fixed rates.

Remember, the type of loan you choose should align with your business situation and financial goals.

Factors To Consider When Choosing Between Variable and Fixed Rates

As a small business owner, several factors should influence your decision between variable and fixed rates:

• Business goals. Are you financing short-term operations or long-term growth? Short-term needs might benefit from variable rates, while long-term plans often favor fixed rates.

• Financial stability. How well can your business handle potential payment fluctuations? If your cash flow is inconsistent, a fixed rate might be safer.

• Market outlook. What's your prediction for interest rates? If you expect rates to fall, a variable rate could save you money.

• Risk tolerance. How much uncertainty can you manage in your budget? Variable rates require a higher tolerance for risk.

• Loan term. Longer terms increase the likelihood of rate changes, making fixed rates more attractive for extended repayment periods.

• Creditworthiness. Your personal credit and business credit scores affect the rates you're offered. Better scores generally mean more options and lower rates.

• Business plan. How does the loan fit into your overall strategy? Ensure your financing aligns with your business plan.

• Startup considerations. New businesses might find variable rates appealing due to lower initial costs, but fixed rates offer more predictability for budgeting.

Carefully weigh these factors against your business's unique needs and financial situation before deciding on your financing options.

Types of Small Business Loans with Variable or Fixed Rates

Small business owners have access to various loan products, each offering either variable or fixed rates:

• SBA loans. These loans, backed by the Small Business Administration, can have fixed or variable rates. They often offer favorable terms but require a lengthy application process.

• Business lines of credit. These are usually variable-rate products, allowing you to draw funds as needed — and great for managing cash flow fluctuations.

• Term loans. Available with both fixed and variable rates, these provide a lump sum repaid over a set period. They are ideal for specific investments or large purchases.

• Commercial real estate loans. Often available with both rate types, these are specifically for property purchases or renovations.

• Equipment financing. Usually, fixed-rate loans are used to purchase business equipment.

• Online lender loans. These alternative lenders often offer both rate types with faster approval processes but potentially higher rates.

• Credit union business loans. These may offer competitive rates in both categories, often with more personalized service.

• Business credit cards. Usually, these have variable rates and are good for short-term financing needs.

• Personal loans for business. While not ideal, these can be an option for startups or those with limited business credit history.

Each lender — whether a traditional bank, online lender, or credit union — may have different offerings and terms. Shop around and compare your options.

How To Determine if a Loan is Fixed or Variable

Understanding whether a loan has a fixed or variable rate is important. Here's what to check in order to figure it out:

• Loan agreement. The type of rate should be clearly stated in your loan documents. Look for terms like "fixed rate" or "variable rate" in the interest rate section.

• Interest rate description. A fixed rate will be stated as a single percentage. A variable rate will reference a benchmark rate (like prime rate) plus a margin.

• APR vs. interest rate. While both loan types have an annual percentage rate (APR), variable-rate loans might list an initial interest rate separately.

• Repayment schedule. Fixed-rate loans typically have consistent payment amounts. Variable-rate loans might show potential payment ranges.

• Rate adjustment terms. Variable-rate loans will include details about how often the rate can change and by how much.

• Loan costs. Look at origination fees, closing costs, and other charges. These can vary between fixed and variable-rate loans.

• Amortization schedule. This shows how payments are applied to principal and interest over time. Fixed-rate loans have predictable schedules, while variable-rate schedules may show different scenarios.

• Prepayment terms. Check if there are penalties for early repayment, which can differ between fixed and variable-rate loans.

When reviewing loan documents, pay attention to the fine print, and don't hesitate to ask your lender for clarification. Understanding the loan's structure, including whether it's a lump sum or draw-based product, can also provide clues about the rate type. The underwriting process and loan terms should be transparent, regardless of the rate type.

Making the Right Choice for Your Business

The right loan type depends on your specific business needs, financial situation, and risk tolerance. Variable-rate loans offer potential savings and flexibility but come with uncertainty. Fixed-rate loans provide stability and predictability but might have higher initial costs.

As you consider your business financing options, take the time to thoroughly understand each loan offer. Don't hesitate to ask lenders for clarification on terms and conditions. Your choice of loan type can be just as important as the lender you choose or the loan amount you secure.

Ready to take the next step in your business financing journey? Visit Clarify Capital to explore your options and find the small business loan that best fits your needs. With the right financing partner and loan type, you'll be well-equipped to fuel your business's growth and success.