Updated September 21, 2022
In March of 2020, the benchmark interest rates were decreased to nearly zero to mitigate the financial impact of the coronavirus outbreak. Since then, the Federal Reserve has been reluctant to increase rates while the U.S. economy is still reeling from its effects. In addition, the economy is currently struggling with high inflation, affecting both businesses and their customers. The Bureau of Labor Statistics reports that the rate of inflation reached a record high of 8.6 percent in May, the highest level since December 1981. As a result, the Federal Reserve recently increased interest rates to control inflation and safeguard the economy though it is unclear how much it will help.
How does raising interest rates slow down inflation?
The Federal Reserve’s key goal is to foster an economic environment that achieves maximum employment and stable prices. The Fed accomplishes these goals by changing interest rates to boost or slow down the economy.
On September 21, 2022, the Federal Reserve increased its key short-term interest rate by 0.75 percentage points for the third time this year, bringing the federal funds rate’s target range to 3 to 3.25 percent. The federal funds rate is the primary benchmark interest rate that banks charge other banks for lending them cash on an overnight basis.
The Fed’s intention when raising the federal fund’s target rate is to raise the cost of borrowing and reduce the availability of money. Customers spend less as a result, which lowers the demand for goods and services. When consumer demand for products and services declines it brings prices back down.
How will higher interest rates affect small businesses?
1. An increase in interest rates may reduce your cash flow.
As interest rates climb, business debt becomes more expensive, requiring more cash to cover the interest costs. Additionally, it may be difficult to qualify for or afford short-term loans to fill cash flow shortages. As a result, the company may have less money to invest in long-term growth or less consistency in its daily cash flow, depending on the general health of the company’s finances and profit margins.
2. An increase in interest rates can make it more difficult for businesses to grow.
Most business ventures inevitably involve some form of debt. Many businesses take out loans or seek financing to give the company the fuel it needs to grow. However, investing in growth may not seem as appealing when considering capital costs because debt servicing costs are higher when interest rates are higher. As a result, growing businesses may find it challenging to take on the debt necessary to continue doing so.
3. A rise in interest rate can increase the cost of goods sold.
Rising interest rates have an impact on the economy as a whole, not only on loans and credit cards. Your suppliers might have to raise their pricing to make up for the higher cost of doing business. Once more, as additional costs rise, you might realize that your monthly cash flow is limited.
4. Interest rate increases reduce consumer spending.
As interest rates rise, consumers will have to spend more money to keep up with the minimum payments on their credit cards, mortgage, auto, and school loans. As a result of the higher repayment costs, they will have less disposable income and must cut back on other expenses. People subsequently start to limit their purchases and stop spending as freely. Especially since they can’t use debt to buy goods or services. Due to consumer spending cuts, businesses can experience a decline in revenue.
What steps can business owners take now to prepare?
This interest rate hike exceeded expectations, and more rate increases will probably continue this year and the following year, so business owners should be ready.
1. Prepare your budget for larger payments now.
The size of your payments may increase along with interest rates, requiring you to set aside more money each month. Make sure you are ready to handle the higher payment without negatively impacting your cash flow.
2. Refinance loans with variable rates.
Examine both your short-term and long-term business debts to determine if there are any opportunities to refinance your variable-rate loans to fixed-rate loans. Even with this rate increase, interest rates are still generally favorable for many different kinds of business borrowing. The time may be right to get a loan with a set interest rate.
3. Analyze your spending.
If you’re worried that your business may suffer, go over your fixed and variable costs to see if there are any areas where you can cut back.
4. Increase cash reserves.
Businesses are less likely to experience short-term operational disruptions when they boost their cash reserves. Additionally, businesses can lessen the likelihood of borrowing money at higher interest rates to maintain their operations by relying on cash reserves to cover price increases.
5. Improve business processes.
If you haven’t already, take a look at your company to see if there are any processes that might be streamlined or tactics that could be used to save money each month. Invest in mechanisms that allow for efficient functioning (e.g. automation).
6. Take advantage of current low rates.
Many business owners have refrained from borrowing throughout the pandemic with good reason. However, if you wait to apply for financing, you can get even less favorable terms or perhaps risk not being approved. Given the rising interest rates, it makes sense to take action quickly if your business needs financing.
7. Consider investing now.
If you’ve been wanting to buy a commercial property, boost inventory, or invest in new machinery over the next year or two, now might be the perfect moment to do so while borrowing rates are still relatively low.
8. Start looking at alternate sources of funding.
In the past, traditional loans from reputable banks were the standard; while they may still make sense for some businesses, many more options are available today. There are several ways to finance your business, including grants, crowdfunding, invoice factoring, merchant cash advances, equipment financing, and fintech lending. Although the rates for these kinds of financing may also rise, they may be better options for some businesses and give you more flexibility in meeting your needs.
9. Keep your finances in good shape.
Businesses with sound financial standing frequently receive the lowest rates. This includes those with solid revenue and good credit scores (personal and/or business). Entrepreneurs can more easily be approved for the best business loans by having good credit and revenue.
10. Create an opportunity fund.
If profits are strong today, save aside some cash to seize any business opportunities that may come your way as loans might not be readily available or affordable.
Rising interest rates can significantly affect you and your business if you are not adequately prepared. It’s time to review your business plans to better position it for the anticipated rate increases. Now is the time to stay ahead of the curve and seek advice from professionals to help you choose the course of action that works best for you and your business.