How Do Interest Rates Affect Your Business?

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Whenever the central bank or monetary authority of a country changes the prevailing interest rate, it usually creates a lot of buzz in the media. More often than not, this is due to the potential impact such a move can have on the entire economy. 

In the majority of cases, any deviation in your country's interest rate will affect you personally, either directly or indirectly; it might change your home mortgage payments, or any other loan payments, for instance. As a business owner, however, the impact will be much more profound. 

The good news is that these changes are not always harmful, depending on the situation and the type of change. Therefore, it is vital to educate yourself about how they will affect your plans going forward and how business interest rates can either create new opportunities – or new challenges – for your fledgeling startup.

How do interest rates work?

All loans carry a certain percentage of interest, which is usually set by banks and is based on various factors (including supply and demand, profit requirement and the degree of risk involved). These rates are then applied to all the credit that these banks provide (such as mortgages, personal loans and business loans), with each type of loan paired with a different rate.

Generally speaking, the central bank of a country is not able to force banks to change these different rates. However, as the chief authority on monetary policy in that jurisdiction, they can make changes to certain kinds of interest rates. 

All banks routinely borrow vast sums of money from the central bank (and other banks) as part of their business model, usually in order to provide new loans for their customers. The central bank then has the power to set the interest rates on these loans. 

Depending on your country of residence, the exact name of this interest rate may vary. For instance, in the US, it is referred to as the Federal Funds Rate; in the UK it is called the Base Rate; in India, the Repo Rate. Regardless of where you are based, the key point is that whenever there is a change in this rate, it causes a domino effect whereby banks are forced to alter their own credit interest rates for customers. It also affects the interest accumulated by investors who deposit money in these banks.

This circulation of money in an economy is like the flow of blood in the human body. Borrowing plays a massive role in it, as it gives businesses and individuals more money to spend. Therefore, if a national bank can control the rate of borrowing and lending, it can have a degree of control over the economy.

So, how can all of this affect your business?

Higher Interest Rates

For a number of reasons, higher interest rates are generally seen as unfavourable for small businesses, although there are some indirect positives, too.

What is the negative impact of higher interest rates on business?

Of course, the most significant impact of a rate hike on your business would be on any loans or debts that you are carrying. With higher rates, the amount of interest you pay back to your lender each month will increase. 

Unfortunately, nearly all businesses are affected by this since most have long term debt. An unsavoury effect of this change will be reflected in your balance sheet in the form of increased expenses and reduced income, and this is a burden that you will have to carry until the rates are reduced. 

It might impact any short term capital injections you were planning, too, as any short term loans will also be affected. Higher interest rates would naturally make these loans less attractive, while you may have to think twice before applying for other forms of fresh credit. This can make unexpected expenses that much more painful to carry. 

In these circumstances, you may find it harder to grow your business. Unless you have a huge war chest of existing funds and savings, you will probably have to postpone any expansion plans until rates are lowered. 

What about customers?

Higher interest rates also reduce the disposable income levels of the average consumer, which is bad news for business. Depending on the type of company you run, the impact of this will vary, with those that deal in non-essential or luxury goods more likely to be affected than those that provide essential items and supplies. 

Are there any positive impacts of higher interest rates?

Luckily, it's not all doom and gloom when the central bank hikes interest rates. If your business has significant cash reserves, this is the time to keep them in the bank. Higher interest rates mean more interest income on any deposits you have with a bank. 

This is a delicate balancing act to play, though. Look at it this way – you do not want to keep all your money stashed up in an account. Most of the time, it is being put to use in buying up assets or producing more goods. Since short term loans will be more expensive after rate hikes, you will be using more of your own funds instead of loans. 

Another marginal improvement may come in the shape of consumers who earn a fixed income, such as a pension. These are often positively affected by interest rate hikes, resulting in higher spending capacity for these categories of consumers. If your business deals with such demographics, then you might see some benefits.

Lower Interest Rates

Conversely, lower interest rates are generally associated as representing good news for entrepreneurs.

What is the positive impact of lower interest rates on business?

As you can imagine, the impact in this instance would be almost diametrically opposite to what you would get in the case of a rate hike. Indeed, a lower interest rate is usually constructive for businesses due to multiple reasons.

For starters, loans are much more attractive – especially the long-term variety. Taking on debt at this point will reduce your long-term costs, resulting in savings. You may also be able to refinance some of your existing debt under more favourable terms., so, if you want to restructure your business debt, then this would be the perfect time to do it. 

Business expansion and growth also becomes easier during this period. This is the right time to take out loans to finance your growth, with cheap loans also allowing you to keep your existing cash reserves parked in high-interest deposits and accounts.

What about customers?

Likewise, lower interest rates are conducive to sales as consumers are encouraged to spend more. This applies to both B2B and B2C segments of the market, too; if you supply goods to other businesses, you will experience more sales as those firms have easy access to cash. The same also holds in the case of individual consumers.

Are there any negative effects to lower interest rates?

There are long term adverse effects on the overall health of the economy, and a weak or failing economy will undoubtedly affect your business as well. However, the biggest threat to a growing business from lower rates is risky spending. 

With the availability of cheap credit, you can end up overextending your company in many ways. Unbridled growth and expansion could end up becoming unsustainable in the long run; new branches may shut down, for example, but the debt you create in the process will remain. Therefore, it is always important to keep a level head when it comes to making expansion plans at such times.

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There are a wealth of political, economic and social factors that can affect your business, and one way to mitigate against such risks is to conduct a thorough PESTLE analysis. For the most part, though, interest rate levels increase and decrease in cycles. There will be periods where things will be lean, and prudent financial management at this time will work in your favour. On the flip side, there will be productive patches, too, and the key is to always take the rough with the smooth.

How else can business interest rates affect your business? Let us know in the comment section below.