Fixed Rate vs. Variable Rate Business Loans: How to Decide
Variable rate and fixed rate business loans may state the same rate despite having vastly different interest costs. So understanding the difference between fixed rate and variable rate business loans is critical.
To help you distinguish these interest rate types, this post will first explain what fixed and variable rates are. Then, we’ll review the benefits and downsides of each so you can determine which type of loan option is right for you.
Defining Fixed and Variable Rate Business Loans
A fixed business loan carries a set interest rate that remains the same over the life of the loan.
An adjustable rate business loan starts with a set interest rate that changes based on current market rates at a predetermined date. As Investopedia explains, “The interest charged on a variable interest rate loan is linked to an underlying benchmark or index, such as the federal funds rate.”
For instance, suppose you take out a 5/1 variable rate business loan. In this example, that five percent rate is set for five years. At the end of that five-year period, depending on how current market rates have changed, the interest rate will be adjusted. It can go up, down, or stay the same, depending on the current market rate.
If this example loan was a fixed rate business loan, that initial five percent interest rate would never change.
The Pros and Cons of Fixed Rate Business Loans
Fixed rate business loans can be more or less cost-efficient depending on how interest rates move. For example, if you lock in a fixed rate loan and then rates go up, you’re getting a good deal. If, on the other hand, you lock in and rates go down, you could’ve saved money with a variable rate loan.
Typically, the longer the term of your loan, the more interest rate risk you’ll face. As a result, for longer term loans, fixed rate loans are less risky.
Besides potential cost benefits, fixed interest rates also give you predictability by keeping your payment constant. As a result, you don’t have to regularly adjust your projections and budget based on a fluctuating loan payment.
The Pros and Cons of Variable Rate Business Loans
Variable rate business loans typically offer a lower introductory interest rate than a fixed rate loan. So initially, variable rate loans will be more cost-effective than fixed rate loans.
However, variable rate loans expose you to the risk of rising interest rates. If market conditions cause an increase in interest rates, your loan payments will increase. At the same time, if interest rates decrease, a variable rate loan can be a great deal.
A general rule of thumb is that the longer the term of your variable rate loan, the riskier it is. After all, the longer your loan term, the greater the risk is that interest rates will increase at some point.
In some cases, rate increases can cause your business financing to become unaffordable. This is what happened to many home buyers who took out adjustable-rate mortgages during the subprime mortgage crisis.
That said, variable rate loans often have interest rate caps. These caps are designed to protect you if rates rise to extremely high levels by setting a ceiling (or “cap”) on your loan’s rate. Still, even with an interest rate cap, your rates can rise by multiple percentage points.
It’s also important to note that if you pursue a business line of credit instead of a term loan, it will usually come with a variable rate. This is because credit lines typically provide more flexibility in terms of repayment.
Fixed Rate vs. Variable Rate Small Business Loans
Studies have found that borrowers are likely to pay less interest with a variable rate loan compared to a fixed rate loan. Of course, past performance isn’t necessarily an indication of future results.
Deciding between fixed and variable rate small business loans boils down to:
- The loan term: as loan term lengthens, the interest rate risk of a variable rate loan increases and vice versa.
- Current and future market conditions: if interest rates increase, the cost of a variable rate loan increases and vice versa.
- Your preference for predictability: no one knows for sure how interest rates may or may not change over time. However, monthly payments on fixed rate loans stay constant no matter what.
Unfortunately, deciding between these two loan types is not black and white for most business owners seeking additional financing. You can successfully finance your business with either financing option. Ultimately it comes down to personal preference, risk tolerance, cash flow, and the consideration of your business’s short term and long term goals.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.