What the Federal Reserve's Prime Rate Hike Means for Small Business Owners
In December 2017, the Federal Open Market Committee (FOMC) voted to raise the Federal prime rate from 1.00 - 1.25 percent to 1.25 - 1.5 percent. Any decision to increase interest rates has an effect on business owners. Small business owners must be especially vigilant about any source of increased costs to their operation.
Federal Reserve President John Williams stated recently that the U.S. economy is growing at a strong pace. In fact, it’s chugging along on all cylinders, meaning that Federal Reserves’ policymakers are predicting that interest rates will increase this year in three hikes of a quarter point each. If the economy continues to grow and inflation becomes a concern, a fourth rate increase may be added at some point in 2018 to attempt to slow down an overheated economy.
What is the U.S. Federal Prime Rate?
The U.S. Federal prime rate is a short-term rate used by banks nationwide. All types of financial institutions use it as a starting point for financing loan products for customers. When calculating the interest rate for loans and mortgages, the lender will take the Federal prime rate and then add a certain number of percentage points based on the level of risk that a customer presents. This “prime + X” formula makes it easy for customers to shop around to compare rates when looking for financing.
Customers who have good credit ratings may qualify for fewer percentage points being added than ones with fair or poor credit. If you are prepared to offer your home or other significant property as collateral for a loan, you may also qualify for a preferred interest rate.
How Prime Rate is Set
While each U.S. bank can set its own prime rate, the number is tied to the Federal Funds Target Rate (FFTR). This Federal prime rate is set by FOMC, a committee which is part of the Federal Reserve. The FOMC meets regularly throughout the year. During these meetings, committee members vote on whether the FFTR should be changed. If the FFTR changes, the Federal prime rate also changes.
Impact of Prime Rate Increase on Fixed-Rate Loans
If you have already taken out a fixed-rate loan for your small business, you are likely in good shape to ride out the impact of higher interest rates. Your payments won’t increase over the term you've agreed upon with your lender.
Future interest rates should be on your mind before you take on any new debt. Once the federal prime rate increases, rates for all kinds of loans will go up. If you are thinking of taking out a loan in 2018, you may want to see whether you can arrange the financing earlier in the year as opposed to putting it off. Rates could be 0.5-0.75 percent higher (or more), depending on how long you wait to sign an agreement with a lender.
Impact on Variable Rate Loans, HELOCs, Lines of Credit
As soon as the prime rate increases, the rate you pay for a variable rate loan, HELOC (home equity line of credit) or a line of credit goes up right along with it. The interest rate for these financial products is tied directly to the prime rate.
You’ll need to take a look at your cash flow projections and have a realistic look at how much more you will be paying for any products with variable interest rates once interest rates start to climb. If you still feel comfortable with variable rate loan products for the time being, contact your lender to ask about your options for converting a variable rate loan or line of credit into a fixed-rate loan. This is a situation where the more you know in advance about your options, the better you’ll sleep at night as interest rates continue to make the news.
Equipment Financing and Higher Interest Rates
As interest rates rise, so does the cost of financing equipment for your small business. This environment demands that you become more diligent about looking at solutions to your equipment needs before making a decision. It may not always make sense to buy equipment outright or to buy brand new.
Before making a purchase for your small business, consider your needs carefully, including how often you need the equipment, how long you expect it to last, and the likelihood that it would need to be serviced during its lifetime. Then start looking at your options:
Is buying new equipment your only choice?
Can you buy the equipment you need used and get the features you need?
Is leasing the equipment an option for something you only need for certain projects or during peak times?
Does leasing make more sense, since the rental company would be responsible for maintenance and repairs to the equipment?
Run the numbers for buying vs. leasing equipment from a tax point of view before you make your decision as well. If you buy outright, the interest on the loan payments is tax deductible and you can also deduct the cost of equipment in the year it was acquired under S. 179 of the IRS Tax Code, up to a set limit (for 2018, the limit is $1 million). When leasing, the full amount of the payments is tax deductible. You can also take a deduction for the full retail cost of the equipment (which may exceed the amount you pay in leasing costs).
If interest rates are rising (which would increase the amount of the deduction for buyers), figure out which option makes the most sense for your small business, bearing in mind that you want to continue to ensure a healthy cash flow.
Rising Interest Rates and Buying a Business Vehicle
Are you interested in buying a new vehicle for your small business? Whether you want to buy one car or truck or put a small fleet on the road in 2018, with interest rates set to rise this year, you are looking at higher financing rates. Dealerships may be able to offer lower rates than banks or credit unions; however, it’s always a good idea to shop around to find the best rates when buying a vehicle for your business.
Good News for Savers When Interest Rates Rise
If there's a silver lining in the cloud of higher interest rates, it comes in the form of higher interest paid on savings. When the FOMC raises interest rates, banks pay out more on deposits. You may be able to earn more in interest on funds you are able to put aside after you pay your business-related expenses.
As always, look at your options carefully to make the most of your money in this higher interest-rate environment. If you need advice on how and when to apply for financing for your small business, including applying for the SBA 7(a) loan, give us a call and we'll share our advice from our years of capital markets experience. Set up your free consultation today with our friendly SBA7a.loans team.