How do interest rates affect businesses?
Interest rates go up and down - and right now, they are at a historic low.
Most of us are familiar with the effects a change in interest rates will have on our mortgage payment. If rates fall, so can the money we are obliged to pay to the mortgage company each month, and the reverse is true when rates go up. Our mortgage repayments go up with them.
But what are the effects of interest rates on business?
Just what are interest rates?
Credit - or borrowing - is the most common form of finance. You borrow from a lender and pay a percentage charge, known as interest, in return for the money you borrow.
The interest rate is the percentage rate charged on a loan. For example, an annual interest rate of 5% means £5 is paid in interest for every £100 saved or borrowed. The higher the rate, the more the lender is charging you for borrowing you the money you need.
With most types of short-term business loans, interest rates are fixed when you take out the loan. They can’t go up or down once you have agreed on the loan deal. However, some other loans - usually for larger sums and over longer periods - can vary.
Usually, these variations do not just occur at the whim of the lender. They are a reaction to an increase in the Bank of England base rate. The base rate - more technically the bank lending rate - defines how much it costs banks and lenders to borrow the money they lend out to you.
The base rate is important for everyone because it's the interest rate the Bank of England will charge to lend money to commercial banks. It's also used as a benchmark rate for banks when they lend money to businesses and individuals.
So when the bank rate goes up, a lender may want to increase your payments to keep their margins healthy. But to be fair, they may also pass on savings if the Bank of England rate goes down.
To make sure that everybody can see exactly what is going on, many loans are priced at a percentage over base rate. So, if you take out a loan at 5% over base rate, you will always pay 5% more than the base rate to the lender. The base rate is currently 0.1%, so you pay interest on your loan at 5.1%.
If the bank rate went up to its historical average of around 5%, you would pay 10% on your loan, and if it went back to the 15% which it hit for a short time in a financial crisis in the 1990s, you would be paying 20%.
What happens to businesses when interest rates change
A change in interest rates will affect your business even if you don’t have loans.
Customers with debts have less income to spend because they are paying more interest to lenders, such as their mortgage company, and sales fall as a result.
The impact of a change in interest rates varies from business to business. The standard economic theory is that firms that make or sell luxury goods are hit hardest when interest rates rise. This is because most customers cut back on non-essentials when their disposable incomes - the cash they have left over after dealing with the essentials - fall as a result of the interest rate rise. However in the long term, with saving being more beneficial, consumers will generally make larger purchases of bigger items which they have made a long-term decision to purchase.
- Firms with overdrafts and flexible loans will have higher costs at the same time as their customers become more reluctant to buy
- When interest rates fall, consumer spending will generally increase due to poor returns on savings and they will be more likely to make impulse purchases
- As interest rates increase, consumer spending will generally drop in favour of saving in the short term.
Exports and the value of the Pound
One of the other effects of an increase in interest rates will be to increase the value of the pound. This is because an increase in interest rates demonstrates confidence in the currency which, in turn, increases demand, which then increases value.
This will affect your business if you import or export goods to other countries. If you import goods, a strong pound is good news for your business as you will be able to buy them cheaper. If you export goods, a stronger pound will mean they are more expensive for your buyers in other countries so you may see a drop in demand.
If your business owns mortgaged property, your mortgage will be on a variable rate. Variable-rate mortgages follow Bank of England base rates very closely so, if these rise, it is likely the interest rate on your mortgage will also rise very quickly.
On a mortgage of £200,000, a rise of even 1% is an extra £2,000 your business needs to find each year.
Obtaining business funding
An increase in interest rates will generally mean that there is a reduction in bank lending because the risk of businesses not being able to afford to repay increases. When interest rates rise it will, therefore, become more difficult to obtain finance and it will also be more expensive.
Interest rates are low and can probably go no lower, so it may be worth looking at your borrowing needs now, especially if you can secure a fixed rate for your loan. At Rangewell, we have experts who understand every aspect of business lending and the challenges you face when you are looking for the funding your business needs. Our team are always happy to discuss the possibilities and to work with you to find the solutions your business can benefit from.
We can help you find the most competitive rates from lenders across the entire market - giving you an advantage whichever way interest rates move. Simply call us to discuss the types of lending you may need. Our service is free.