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Raise, Cut or Hold Interest Rates? How Federal Reserve Action Affects Your Startup.

With core inflation remaining steady or declining in recent months, the Federal Reserve held the line Wednesday on interest rates. But that does not mean entrepreneurs and small business owners can bank on things staying the same over the next few months.

The strong economic performance in the second quarter is welcome news to those of us running small operations or even trying to grow side hustles. But that very economic strength can cut both ways when the Federal Reserve remains concerned about inflation.

The decision this week on whether to raise, lower or hold interest rates at their current 5.25% to 5.5% range is one thing. The more intriguing question may be what comes next. Will the Fed signal the possibility of additional interest rate increase in the next few months? And what is the potential course for rate cuts in 2024?

Core inflation, the main metric the Fed looks at, has continued to cool. It came in at a 3.7% annual rate in September, a continuation of the slowing pattern we’ve seen most of the year. And while the job market remains strong, labor supply and labor demand appear to be finding some balance. Wage growth has slowed accordingly.

Of course, all this strength is good news for business. But, as we said, it can cut both ways with the Fed.

Tracking the Fed’s thinking on inflation and interest rates can be a challenge on top of all the tasks that come with starting a new business—managing the books, acquiring customers, ensuring positive cash flow and so on. But if you are a startup and navigating your way through the world of business financing, you will want to keep in mind how interest rate increases may potentially affect your future decisions.

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How Federal Reserve rate hikes will affect your startup

While the Federal Reserve bank increasing rates has widespread impact from real estate owners to consumers and other businesses, the beauty of being a startup is you’re a startup! You are a new company and decisions that you make on financing are typically for your first business business loan as a new business.

This means you get to avoid the impact of a rate increase by the Federal Reserve, since you don’t have an existing rate of payment to think about. However, what you need to be thinking about is what happens to your loan if the Federal Reserve raises rates after you get your loan.

1.    Do you have a fixed-rate loan or a variable rate loan?

If you’re paying off your loan at fixed interest rates, the Federal Reserve’s rate hike won’t likely impact you. Your interest expense remains the same and your monthly payment doesn’t change.

On the other hand, if you have a variable rate loan, you’re going to feel the difference overnight. Those who took out adjustable rate loans are at risk of getting a big surprise when their lenders charge them with the new Federal Reserve interest rate.

Variable rate business loans will be adjustable monthly, quarterly or annually, which means your interest rate will change and directly impact both your interest expense and your payment.

At this point, you have to revisit your financial forecasts and see how you can manage the upcoming interest surges resulting from hikes by the Federal Reserve system.

2.    You’re going to pay more in interest

If the Federal Reserve increases rates, so does your interest expense. Interest is typically charged on the average outstanding monthly principal balance of your loan, therefore if rates go up so will your interest cost. Make sure you have enough margin in your business to support the margin compression due to higher interest expense.

3.    Your payment is going up

For a startup,  cash flow is king and any impact to daily cash flow can have a big effect on a new business. When the Federal Reserve bank increases rates, your payment will go up, which means you will be responsible for a larger payment monthly.

If you have an existing loan, keep an eye on your rate adjustment period to make sure you are prepared for the increased payment.

Here is an example:

Before Federal Reserve Rate Hike  After Federal Reserve Rate Hike
Principal balance $100,000.00 Principal balance $100,000.00
Interest rate 3% Interest rate 3.5%
Term (years) 5 Term (years) 5
Monthly payment $1,796.87 Monthly payment $1,819.17

4.    Start exploring other financing options

Considering that small business loans are already getting a bad rap with the new Federal Reserve interest rates, now is the time to inquire about alternative funding solutions providing financial services for startups.

Lending options such as invoice factoring will be beneficial to your business since they do not require you to take on debt. There’s also a business line of credit, which allows startups and small business owners to pull out funds from their accounts and pay them back with interest.

Ideally, if you don’t urgently need financing but you need sufficient funds for equipment repairs or other emergencies, you could opt for a credit line from your lender.

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5.    Traditional lenders may potentially ease their qualification requirements

When the Federal Reserve system sets high interest rates, it can have a net positive impact on business owners in the short term.

Following the Great Recession in 2008 and the challenges it created for the Federal Reserve and financial system, traditional banks all but closed their loan offerings to small businesses citing high risk and low profit margins. With increasing rates, banks will begin to offer loans to small businesses increasing competition against alternative lenders.

6.    If you’re planning to get a small business loan, do it sooner rather than later

While you might not feel the impact of the Federal Reserve’s interest rate hike now, if this trend continues over the next couple of years it will affect small business loan rates. It’s one reason to take a look at applying for a business loan now rather than later.

Here are some tips to think about:

  1. Keep your margins high enough to support higher interest expenses.
  2. Make sure you have enough working capital to support higher payments.
  3. Ask your lender for a longer term to lower your current payment.
  4. Lock in a fixed rate or a rate ceiling so you can have better control of future interest expense.
  5. Borrow less if you don’t need all the money. This, of course, has a direct impact on monthly payment and interest expense.

The bottom line

Even though startups and small companies will feel the impact of the Federal Reserve bank interest rate hike, you need to look at the broader picture. As interest rates are increasing, consumers tend to save because their returns from savings are higher. With less disposable income being spent, the economy slows and inflation decreases.

With the upcoming changes to the market and financial institutions like the Federal Reserve system not giving a clear signal on how many times they’re going to raise the rates in 2022 and beyond. You may want to decide if it makes more sense to get a loan today while the rates are low or take the chance in the future with them being higher as a result of the hikes by the Federal Reserve.

Remember that outside of the decisions made by the Federal Reserve bank, the rate you get will still vary on a number of different factors such as your credit score, your industry, and length of time in business. As founder or chief executive officer of a startup, now is the time to revisit your financials and look at your long-term growth plan and decide on the best decision for your business.

Interest rate hikes brought on by the decisions of Federal Reserve board can have a significant impact on startups. While it may be difficult to predict exactly how interest rate hikes will affect individual businesses, it is important for entrepreneurs to be aware of the potential consequences.

Startups should consider exploring alternative funding options to the Federal Reserve system and maintaining a strong financial position to weather any potential changes in the interest rate environment.

Additionally, keeping an eye on consumer spending patterns can help startups adjust their strategies and stay competitive in a changing economic landscape.

By staying informed and adaptable, startups can continue to thrive even in uncertain times.

This post was originally published in February 2022.

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