Fixed vs. Variable Interest Rates: What’s Best For Your Small Business Loan?

A small business loan’s interest rate is an important choice that can affect both businesses’ future development and financial stability. Small business owners in Australia may often find themselves choosing between fixed and variable interest rates. This is why it’s vital for them to understand how small business loan interest rates work.

Understanding how interest rates work involves considering the factors that influence them and the advantages and disadvantages of each type. This may help companies ensure the interest rates they choose are suitable for their business needs.

This article will attempt to examine the distinctions, advantages, and difficulties of each rate type to assist businesses in choosing what’s their best course of action.

Understanding Fixed And Variable Interest Rates

Every small business loan type has its interest rates. The interest rate is essentially the cost of borrowing a loan. The most commonly associated rates with business loans are fixed and variable.

Fixed interest rates remain unchanged throughout a loan. Regardless of changes in the market, the rate that was agreed upon at the start of the loan remains the same.

The repayments every month may be predictable when a business has fixed rates, making budgeting simpler than with variable interest rates.

In contrast, market factors and changes in the Reserve Bank of Australia’s (RBA) cash rate may lead to variable interest rate fluctuations. Variable rates may be subject to frequent changes by lenders. This means that monthly repayments may fluctuate throughout the course of the loan.

Pros And Cons Of Fixed Interest Rates For Small Business Loans

Fixed interest rates come with their own set of advantages and disadvantages. Some of the pros of fixed rates include:

• Predictable repayments: Fixed rates offer predictable repayments, meaning businesses may know exactly how much they owe each month
• Easier budgeting: Because the rates remain unchanged, it may make it easier for businesses to budget repayments and plan for financial growth
• Protection from rate hikes: Fixed rates may protect businesses from worrying about potential spikes in the market interest rates

On the other hand, the most common cons of fixed rates are:

• Higher costs: Over time, fixed-rate loans have typically cost more than variable-rate loans
• Less flexibility: There are often restrictions in terms of making extra repayments or refinancing with fixed rates
• Potential break fees for early repayment: If a business wants to repay a loan early, it may, in some cases, be required to pay a break fee

Generally, fixed interest rates are best suited to businesses with a steady income and predictable cash flow. Moreover, fixed interest rates may be the better choice if there are predictions for potential rate spikes.

Pros And Cons Of Variable Interest Rates For Small Business Loans

As with fixed rates, there are also advantages and disadvantages to choosing variable interest rates. Some of the most common pros of variable rates are:

• Potential for lower initial rates: Variable rate may potentially start lower, which may also reduce the initial cost of borrowing
• Flexibility: With variable rates, businesses can often make additional repayments without penalties. This reduces the loan terms and interest
• Easier refinancing: Businesses may have an easier time refinancing with variable rates if a better loan option is available in the future

In contrast, the potential cons of variable rates typically include:

• Unpredictable repayments: Businesses may experience fluctuations every month with variable rates, making repayments unpredictable
• Risk of rate increases: If the market rate rises, it can lead to a rate increase, which can make repayments more expensive
• Budgeting challenges: Variable rates might make budgeting more challenging due to their unpredictable nature

Variable rates could be more suitable for businesses looking for more flexibility or planning to refinance in the future. Also, variable rates are usually considered the better choice if there are predictions for potential market rate decreases.

Key Factors To Consider When Choosing Between Fixed And Variable Rates

• Loan term and purpose: Variable rates can benefit short-term loans because of possible savings, but fixed rates may be more appropriate for long-term loans because of stability.
• Cash flow stability: Businesses with steady revenue streams may handle variable rates more easily. For businesses with fluctuating cash flow, fixed rates offer more stability.
• Risk tolerance of the business owner: Fixed rates may be beneficial for risk-averse business owners. However, for businesses with higher risk tolerance, variable rates offer potential savings down the line.
• Market trends: Variable rates are better when rates are anticipated to decline, whereas fixed rates are better in a situation when rates are likely to rise.

Hybrid Loan Options: Combining Fixed And Variable Rates

Split loans, also known as hybrid loans, are a type that may be split into multiple parts. For example, one part with a variable rate, and the other with a fixed rate. With its combination of flexibility and stability, this structure generally provides the best of both worlds.

• Risk mitigation: Potentially prevent significant rate increases while enabling businesses to take advantage of future rate reductions
• Flexibility in budgeting: The variable component can allow for additional repayments or refinancing, while the fixed element offers businesses predictable repayments
• Personalisation: Businesses can potentially change the ratio of fixed to variable components according to their budget

Hybrid loan options are typically suitable for businesses that may be undecided on which option is better for them. Moreover, split loans may also be more beneficial if the market rate fluctuations are uncertain.

Frequently Asked Questions

What happens if market interest rates drop while I'm on a fixed-rate loan?

Businesses with a fixed-rate loan will remain with the same repayment amount even if market interest rates drop.

Is a split (hybrid) loan a good option for small businesses?

Whether a hybrid loan may be a good fit mainly depends on the business’s needs. For instance, businesses looking to strike a mix between stability and flexibility may find split loans to be a great option as they offer the best of both worlds.

Conclusion

The business’s financial situation, level of risk tolerance, and the state of the market will all play a role in deciding a suitable small business loan interest rate for the business. 

Businesses that seek stability may find fixed rates excellent because they remain unchanged. In contrast, variable rates tend to offer flexibility and the possibility of cost savings if market rates decline.

However, if a business looks to capitalise on the benefits of both options, it can explore the potential of securing a hybrid loan.

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