How do interest rate changes affect businesses?

Interest rates play a pivotal role in the financial landscape, significantly impacting both individuals and businesses.

They are essentially the cost of borrowing money, acting as a percentage of the principal loan amount that borrowers must pay to lenders in addition to the loan itself.

While they might seem like mere numbers, interest rates can profoundly influence a business's operation and growth.

In this guide we’ll outline what an interest rate is, how it’s set, and what impact a change in the interest rate can have on your business and its finances.

When thinking about applying for any financial product, it’s a good idea to first seek independent specialist financial advice to make sure the product is right for your circumstances.

What is an interest rate?

Interest represents the cost you incur for borrowing money, and conversely, it's what banks reward you for depositing money with them.

Interest rates are typically expressed as a percentage of the total amount of money you borrow or save over a year.

For instance, if you deposit £500 into a savings account that offers an annual interest rate of 2%, you will have £510 in your account after one year.

What influences interest rates?

The Bank of England base rate is the most important interest rate in the UK and influences the interest rates offered by commercial banks to businesses and individuals.

The Monetary Policy Committee sets the base rate and is primarily used to help maintain the inflation target of 2% set by government.

Since the Bank of England base rate determines how much money the Bank of England itself pays to commercial banks, any base rate changes have a knock-on effect on the rates those banks charge their customers to borrow money or pay out on their savings.

However, the bank rate isn’t the only thing that affects borrowing and saving interest rates.

Interest rates can change due to a variety of factors and may not always align perfectly with shifts in the base rate.

In managing their operations, commercial banks need to ensure that the interest they pay on savings is less than what they earn from lending; this is vital for covering their costs.

However, they can't offer less than 0% on savings as this would deter people from depositing money with them.

Consequently, when the base rate approaches 0%, banks are less likely to fully reflect this in reduced savings and borrowing rates.

Similarly, as the base rate begins to climb from near-zero levels, it's probable that there will be a smaller corresponding increase in both savings and borrowing rates.

This is because banks must maintain a balance between attracting depositors and ensuring profitability from their lending activities.

How does a change in interest rate impact my business?

A change in interest rates can have a big impact on the finances of a business.

Whenever the Bank of England changes its base rate, it impacts how much commercial banks charge their customers for borrowing money, or how much they pay them for keeping money with the bank in the form of savings.

This in turn affects how much people spend in the wider economy, therefore influencing pricing and inflation, the rate at which prices for products increase and the purchasing power of money falls.

It’s the role of the Bank of England to revise their base rate upwards or downwards to keep inflation at the 2% target mandated by Government.

Generally speaking, lower interest rates boost the value of wealth such as pensions or housing, reduce the cost of borrowing money, and make saving money less rewarding.

This tends to increase the amount of money people spend as there are fewer incentives to save it.

However, in a high interest rate environment the inverse is true, and this can have a negative impact on businesses.

In an environment with high interest rates, businesses may have to balance rising fixed costs like labour or supplies whilst remaining competitive in a market where customers have less overall money to spend and so become more cost conscious.

How do interest rate changes affect a business loan?

Another impact changes in interest rates can have on business is its impact on the cost of borrowing money from a commercial bank, although this is dependent on what type of business loan rate you are offered.

What are the types of business loan rate?

The cost of taking a loan out with a lender is known as the business loan rate and is reflected as a percentage of the total amount you borrow.

Each loan comes with a specific interest rate, which can be influenced by several factors.

It's crucial to understand that the interest rate on a business loan is contingent upon the repayment period and any collateral that may be provided.

There are three main types of business loan rate that can be found in the market.

Fixed rate loan

A fixed rate refers to an unchanging interest rate, agreed at the point you confirm the terms of the loan with the lender, that remains consistent throughout the tenure of the loan.

This allows you to calculate the exact amount of interest you'll be liable for, providing certainty that this figure will not fluctuate as you gradually repay the loan.

Variable (or floating) rate loan

A variable or floating rate, while potentially starting out lower than a fixed rate, carries the possibility of increasing or decreasing throughout the loan's duration, based on prevailing market conditions.

For instance, should the Bank of England adjust interest rates nationwide, your individual rate would be adjusted accordingly by your lender to align with these changes.

This means your interest payments may fluctuate over the life of the loan.

Hybrid rate loan

Though quite rare, hybrid rates offer a blend of fixed and variable rates, providing a unique balance for borrowers.

This loan structure is designed to shield borrowers from potential hikes in interest rates, while simultaneously offering the benefit of capitalising on any drops in rates.

This dual-feature makes hybrid rates an attractive option for those seeking both security and the potential for lower repayments.

What determines the interest rate I can get on a business loan?

In addition to the Bank of England base rate, there are a number of factors a lender could take into consideration when determining what interest rate to offer you for a loan.

Every lending institution follows unique policies when determining business loan rates.

Certain lenders might provide special programs or discounts to specific types of businesses, while others may impose higher rates for particular loan categories.

It's crucial for borrowers to evaluate offers from various lenders prior to making a loan selection.

By thoroughly comparing the available loan offers, borrowers can secure the most favourable rate for their loan.

Some of these factors that a commercial bank may take into consideration when setting an interest rate for a loan include:

What type of business you have

Typically, lenders impose higher interest rates on loans for businesses perceived as high-risk, such as newly established start-ups.

In the same vein, loans for real estate investments often come with higher rates compared to other types of business loans.

The size of the loan

The size of the loan is another determinant that influences business loan rates.

As a general rule, larger loans tend to attract higher interest rates.

This is because lenders perceive them as carrying more risk compared to smaller loans.

What your level of creditworthiness is

Interest rates typically serve as an indicator of the lender's confidence in your creditworthiness.

Borrowers who have robust credit histories and strong financial positions are often eligible for lower interest rates, as they present a lower risk to the lender.

On the other hand, if your credit history is marred by poor scores or instances of missed payments, you may be subjected to higher interest rates.

This is because lending to individuals with less-than-stellar credit profiles entails a greater degree of risk, which lenders mitigate by charging higher interest.

Read out guide on the various ways you can improve your credit score.

What you plan to use the loan for

The intended use of the loan also plays a critical role in determining the interest rate set by a lender.

For instance, loans intended for equipment purchase typically come with higher rates compared to those meant for working capital or business expansion.