Fixed-Rate Or Variable-Rate Loans? Which Type Is More Favorable?
Money is the fuel that runs the entire business mechanism. Entrepreneurs looking to grow or just run their businesses uninterruptedly often need to primarily rely on funds. However, there are times when every business, irrespective of its size and trade history, goes through cash flow issues. In such situations, business loans generally turn out to be a true rescuer. But, getting a business loan is not always easy as loan approvals are given only after evaluating the applicants’ trade history, profitability, bank statements, credit scores, available assets, etc., in the case of traditional bank loans. Though alternative lenders are lenient with credit score requirements, they primarily require the profit and loss statements of the businesses along with other mandatory documents to decide on the applicant’s creditworthiness.
Hence, getting a clear idea about their businesses’ as well as the lenders’ requirements is a must for all loan seekers to be able to understand which type of loans will suit them best or they can qualify. Also, loan seekers need to conduct thorough market research to gain knowledge about the reputation of their shortlisted lenders. But, loan seekers often miss out on the calculation of the loans’ costs. To estimate the total cost of a loan, interest rates, which can be fixed or variable, must be taken into consideration. This calculation is quite crucial for the borrowers as it helps them understand how much extra they will end up paying to the lenders at the end of the term.
To determine the costs of different loans, it is very important to figure out the difference between fixed and variable rates. So what are fixed-rate and variable-rate loans? Technically, the former comes with inflexible interest rates that remain the same throughout the loan term, and the latter carries interest rates that rise or fall depending on the altering market rate. For example, if a borrower has taken a 6/1 variable rate business loan, which came with an interest rate of 6% and a repayment term of 6 years, at the end of the decided term, the interest rate will be adjusted as per the currently updated market rates. Though variable-rate loans offer lower introductory interest rates than fixed-rate loans, when the term is long, the borrower always faces the risk of having the initially offered interest rate increased over time, in the case of variable-rate loans. On the other hand, the locked rates never increase or decrease with the fluctuating market rate, when it comes to fixed-rate business loans. This means, even when the market rate has considerably decreased, the borrower of a fixed-rate loan needs to continue paying the fixed rate till the term ends.
However, both types come with certain advantages and disadvantages. For some businesses fixed rate business loans are beneficial and for others, variable rate business loans are more suitable. This is because every company has unique requirements and conducts business differently, based on multiple factors.
To decide between fixed and variable rate business loans, one must consider his/her desired repayment term, the current market rate and its chance of rising, his/her risk tolerating capacity, and the current financial condition of the business, i.e., if it is experiencing limited or substantial cash flow. When it comes to the market rate, it usually rises when the economy is growing too fast and inflation is happening quicker than predicted. It tends to fall when the economy is getting weak, financial markets are facing immense pressure and the government is looking to stimulate growth. The market rate continues to stay the same only when the economy is growing moderately.
Things to keep in mind while deciding which type of interest rate will be most beneficial:
- In the case of fixed-rate business loans, borrowers will have an idea about the exact monthly repayment amount and hence, can plan expenses accordingly. Neither borrowers will have to pay more than their priorly allocated repayment amount if the market rate goes up, nor they will be able to reap the benefit of the reduced market rate when it goes down. For small businesses, fixed-rate loans often come with comparatively higher interest rates. But, those who dislike uncertainty and don’t want loans to damage the stability of their businesses in any situation, often find fixed-rate loans beneficial.
- When it comes to variable-rate loans, the initial interest rates offered to small businesses are quite low. Lenders always lower the interest rates of the ongoing loans when the market rate goes down and raise the same when the market rate goes up, and the total payable amount as well as the monthly payments decrease or increase respectively.
As mentioned earlier, both fixed-rate and variable-rate business loans are gainful, if looked at from different perspectives. Hence, to understand which one is the right choice for the company, the business owner needs to take into consideration, the primary reason/s he/she is planning to take a loan, his/her financial and mental capacity to take a risk, and predictions about the chance of the market rate changing in the coming years, especially over the loan term, he/she is looking to qualify for.