If you’re starting a new business or looking to expand an existing one into new products and markets, you need reliable access to money. When it comes to securing funding, you have a few different options.
Lenders provide many types of loans, and two of the most popular are fixed interest rate loans and variable interest rate loans. We’ll break down the differences between the two so you can decide what’s right for you.
Before we get into the details, it’s worth saying what we mean when we use these terms below:
- 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 your business has 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.
- Spread: The difference between the base interest rate and the interest rate that a loan provider offers your small business. This difference is how they make their money. For example, the base rate might be 1.5%, but a lender offers you a rate of 8%. The spread would be 6.5%.
What is a Fixed Interest Rate Loan?
A fixed interest rate loan for your small business means you borrow money at an interest rate that’s set when you take out the loan. That interest rate generally won’t go up or down for the duration of the loan, even if the base interest rate rises or falls. Fixed rate loans are good for several reasons:
- You know what the monthly repayment will be and can budget your business expenses accordingly.
- If the interest rate rises, it won’t impact the overall cost of your loan.
- Fixed rates mean you can manage your cash flow in a more precise way to protect your business.
Fixed rate loans do have a couple of disadvantages though:
- 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.
What is a Variable Interest Rate Loan?
A variable rate loan means your small business can borrow money at an interest rate that may go up or down over time. For example, if the base rate rises by 0.5%, the rate on your loan will rise from 8% to 8.5%. Variable rate loans are good for several reasons:
- 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.
Variable rate loans do have some disadvantages:
- 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 operational expenses, especially if you have a tight cash flow.
When Does the Base Interest Rate Go Up or Down?
When you’re making the decision on whether to take out a fixed or variable rate loan for your small business, it’s important to understand what might cause the base interest rate to change.
- Base interest rates tend to rise when the economy is growing too quickly and inflation (the rise in the overall cost of goods and services over time and the reduction in the value of money) is going up faster than intended.
- Base interest rates tend to fall when the economy is weak, when financial markets are under pressure, and the government wants to stimulate growth.
- Base rates tend to stay the same when the economy is growing at a reasonable pace and there is low, manageable inflation.
There are many other factors that can influence the base interest rate, but this is a good starting point.
Which is Better, a Fixed Rate or Variable Rate Small Business Loan?
The answer is, “It depends.” To make the best decision for your situation, consider the following:
- Is the cash flow in your business quite tight, and is your cash cushion fairly small?
- Do you want predictable monthly payments that won’t vary over time?
- If your monthly payments increased, would that damage the stability of your business?
- Are you willing to pay a little more in interest to get a better sense of security?
If the answer to these questions is “Yes,” then a fixed rate loan is probably the best choice for you.
A variable rate loan might be better for your small business if you answer “yes” to these questions:
- Do you want to pay slightly less in interest for your loan, but lose some of the security of fixed payments?
- Can your small business cash flow handle larger monthly payments for an extended period?
- Do you mind uncertainty in how much you might pay?
Research does show that generally, you’ll pay less on a variable rate loan than on a fixed rate one, but that comes with a big caveat: You need to have enough of a cash cushion and positive cash flow in your business to handle an increase in what you repay each month.
Questions to Ask Your Lender
Make sure you’re working with a trustworthy lender and someone who has a track record of treating small businesses well. We have lots of options on our Connect2Capital platform. Once you have a shortlist of lenders, here are some questions you can ask:
- 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?
This will help you narrow the field. For more practical advice on starting a business with a loan, please see your specialized guide.
We hope you’ve found this useful and that it helps to make the decision on whether a variable or fixed rate loan is best for your small business.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial advice. You should consult with any lenders you’re considering a loan with for their product terms and details.