It’s official, the Fed recently lowered the prime rate, and many are wondering: how does the prime rate change affect small business? It seems like every financial act impacts small businesses in some way, for better or for worse. Here’s what you need to know about the prime rate change and how it affects small business.
What Is The Prime Rate?
The prime rate is the interest rate determined by the Federal Open Market Committee (FOMC) that acts as a target lending rate banks should give to their premium clients. Banks are not forced to charge that rate, but it influences much of the lending market.
The federal funds rate is what banks charge other banks for overnighting lending from their reserve balances. Banks are required by law to maintain a certain level of reserves depending on deposits. If they have a shortfall in their reserves, the bank can borrow money from another bank with excess reserves at the prime interest rate.
Eight times a year, the FOMC meets to determine the federal funds rate based on economic factors like potential inflation or recession. If a recession is looming, the rate would decrease to encourage growth and expansion. The FOMC can’t enforce this rate as what must be charged, but the Federal Reserve System can control how much money is circulating in the economy to move interest rates. Increasing the money in circulation can cause interest rates to fall whereas decreasing the money supply can raise interest rates.
How Does The Prime Rate Affect My Loans?
Even if you aren’t a premium borrower receiving prime rates, the prime rate change will still affect your loans. The Fed changes create a ripple effect throughout the finance industry that affect personal loans, business loans, credit card APRs and everything else.
Some business owners use lower rates to refinance. This can extend the repayment terms, lower monthly payments and decrease the rates. The better shape your business is in, the more likely your business is to get premium lending rates, however rates aren’t always guaranteed to stay the same.
Interest rate risk management products can help with the ever-changing and unpredictable interest rates, but choosing which one can be tricky. In a nutshell, a rate swap provides the certainty of a fixed rate to protect against rate hikes, but the flexibility to terminate if the economy stalls. A cap guards against rising short term interest rates by reimbursing the business with cash if the rates rise above a certain level and can be structured (adjusts over the years) or unstructured. A collar, more popular than a cap, provides both a floor and a ceiling, protecting against unexpected hikes but also not allowing the full benefit of additional rate drops.
Using these risk management options to your full benefit requires research or even an expert advisor who can predict the market. It’s hard to know where the economy is headed and which program is worth the fees, but the unpredictableness is what makes risk management all the more necessary.
Is Now A Good Time To Take Out A Loan?
Business owners who don’t yet have any debt but are looking to take out a loan can take advantage of the lower rates, but it’s worth acknowledging that rates are lowered to stimulate growth with a recession on the horizon. Should the recession happen while the loan is still being paid back, profit for repayment could be strained. Don’t take out more money than needed just because rates are low, this could bite you if the economy dips and your business becomes overleveraged or if rates are raised and your business does not have a fixed rate.
The Fed lowers interest rates to encourage growth and expansion. Business owners are more likely to borrow money if it’s cheaper to do so. Typically the Fed will wait until a recession is clearly on the horizon but with so many predictions it will happen in the next year and happen suddenly, the Fed could be trying to get ahead of it. Business expansion might need to be encouraged if growth slows or declines for two or more quarters in a row, specifically looking at growth in the number of jobs created. As the economy has been high for over a decade and enters the longest bear market on record, surpassing the longest expansion period of March 1991 to March 2001, many financial leaders are expecting a recession by the end of 2020.
Many business owners are unsure of ventures into expansion regardless of what the rates might be lowered to. The economy is volatile, and the longer it grows and performs well the more uneasy business owners get waiting for it to slow. A short term loan is best given the constantly changing rates, tariff wars, and other economic and political factors affecting small businesses. Until market forecasts level out, many business owners are operating with smartly calculated financial decisions so that they can still take advantage of these low rates and growth opportunities.
If the changing rates are too challenging to keep up with and plan for the future with, financing your business with a non bank loan or a financial source not tied to Fed rates might prove to be a better option and allow for fixed terms that are easy to forecast cash flow with. Online funding provides short term loans that last 3-18 months instead of several years which can also help free up cash flow sooner in case the market dips. To learn more about FundKite’s online funding, click here to apply or call (877) 502-5003 to speak with a funding specialist.