Fixed Rate vs Variable Rate: Which is Right for Your Business?
The choice between fixed and variable rates is a crucial one for your business loan. Choosing the wrong option could lead to you paying more interest than you need to. Max Funding wrote this article examines each so you can make the right decision.
Most business owners understand that they must pay close attention to the terms of any business loan. Each lender has its own criteria that you need to stick to. If you don’t, your business could end up in trouble.
However, there’s a choice that you need to make before examining any more specific terms:
Fixed-rate or variable interest rate.
You’ll likely have access to both from various lenders. Your choice determines how much interest you ultimately pay on the loan principal. Making the wrong choice means you pay more interest than you need to.
Various market factors play a role in how lenders determine their rates. The Reserve Bank of Australia’s (RBA) cash rate affects what they offer. That means you have to put some thought into which rate you opt for.
To help with the decision, this article examines both rates in detail.
What is a Fixed-Rate Loan?
Fixed-rate loans allow you to fix the interest you pay on the loan for a set period of time. For short-term loans, this may be the entire loan period. With long-term loans, you may be able to set the rate for a few years before the loan reverts to a variable rate.
For example, you could fix the rate at 4.5%. That means you only pay 4.5% interest for every repayment until the end of the fixed period.
This means that the amount you pay doesn’t vary each month depending on the market and the whims of the lender.
When used well, you can use this loan type to lock a desirable interest rate in for a large period of time. As a result, they’re best used for periods of market instability. If you feel that the national cash rate may increase, it’s often best to go for a fixed rate until the market settles.
The Pros of Fixed-Rate Loans
There are several pros to a fixed-rate loan that may make them a good choice for your business. These include the following:
- Predictability. As previously mentioned, various market forces can lead to interest rates changing. These changes don’t affect you when you have a fixed rate. You know exactly how much you need to repay each month or week. As a result, you have more control over your cash flow. You can set aside the exact amount needed for the loan and feel safe in using the rest of your cash for other purposes.
- Potential for Low Interest. If you can lock in a rate during a period of low interest, you benefit in the long term. Again, you don’t have to pay more each month if the national interest rate increases. With good timing, you can lock in a low rate, which ultimately means you pay less interest on the loan principal.
- Easier Planning. The fixed rate also allows you to calculate exactly how much interest you’ll pay over the loan period. This helps when determining if the loan is really the right choice for your business. Furthermore, these figures also allow you to work out exactly how much you can claim in tax deductions.
The Cons of Fixed-Rate Loans
While you may desire the stability of a fixed-rate loan, there are a few drawbacks to keep in mind.
- Poor Timing Issues. As well as a fixed-rate loan may work when you get the timing right, fixing at the wrong time can cause issues. You could fix the rate only to find the national interest rate lowers. This leaves you paying more per month than you would on a variable rate loan.
- Less Flexibility. Many lenders won’t allow you to make early repayments on a fixed-rate loan. Those that do may attach a fee to the repayments. Moreover, it’s unlikely that you’ll be able to draw down on any extra repayments that you do make. You’ll generally find fixed-rate products aren’t as flexible as their variable rate counterparts.
What is a Variable Rate Loan?
As the name implies, variable rate loans allow the interest rate to vary based on other market factors. Chief among these is the RBA’s national cash rate. If the cash rate decreases, the interest attached to your loan tends to go down with it. Of course, an increase also means that you end up paying more.
However, there are other factors that could lead to a rate change. The lender applies its own cost of funding calculations to the rate it offers. If those change, the interest rate of the loan changes with them.
Generally speaking, you’ll choose this type of loan if you believe the national interest rate is likely to fall. This will allow you to take advantage of lower rates than you would have if you fixed the rate.
The Pros of Variable Rate Loans
There are several positive aspects to taking out a variable rate loan that you don’t get if you go for a fixed rate:
- Taking Advantage of the Market. The national interest rate is usually the main factor in place when it comes to loan interest rates. If you secure a variable rate loan when the interest rate is high, it’s likely that your payments will decrease over time. Whenever the national rate decreases, you end up paying less per month. This can give your business a little extra cash to work with for other purposes.
- More Features. Lenders often offer more features with their variable rate loans than their fixed rate loans. For example, you may have the option to make extra repayments on the loan. Doing so allows you to repay the loan quicker, so you end up spending less on interest overall. Some variable rate loans also allow you to draw back these extra payments. This can prove useful if you run into cash flow issues later on down the line.
- More Borrowing Power. Some lenders allow you to borrow more money on a variable rate than they would on a fixed rate. However, this is not a given. It depends entirely on the lender’s policies.
The Cons of Variable Rate Loans
As with fixed-rate loans, there are some variable rate loan drawbacks that you have to keep in mind. These include the following:
- Market Issues. In some cases, changes in the market will actually work against you, rather than for you. If the national cash rate rises, it’s likely that the interest rate attached to your loan will rise too. There’s also the issue of increases made at the lender’s discretion. As mentioned, each lender has its own calculations to determine how much interest you pay. They may make changes that result in you paying more, even if the cash rate stays the same.
- Less Certainty. With a fixed-rate loan, you know exactly how much you’re repaying every month. While this may sometimes be more than you’d pay on a variable rate, you can at least prepare for it. Unfortunately, a sudden market change can have a massive effect on a variable loan. You could find yourself repaying hundreds of dollars more than you did the previous month. This could place the business in jeopardy if you haven’t prepared for it. This lack of certainty makes it harder to forecast your cash flow.
The Final Word
In the end, the loan type that you choose depends on two issues:
- The market
- Your personal circumstances
As a general rule, you should go for a fixed rate if you expect the national cash rate to increase. However, a variable rate may serve you better if you expect the cash rate to fall. Unfortunately, this isn’t an exact science. The RBA may spring a surprise on you, which leads to your plans falling apart.
If you decide to go with a variable rate loan, it’s best to keep some money aside. This covers the lack of certainty that comes with this loan type. If the rates do increase, you can dip into this cash reserve to ensure you continue making your repayments.
If you prefer knowing exactly how much you’ll repay each month, a fixed-rate loan may be the best option for you. Some businesses may find this certainty preferable even if they expect the interest rates to fall.
Think about what works best for you before applying. As always, pay close attention to the other features that the loan offers too.
Max Funding provides several loan types for you to choose from. Apply today to find out if you qualify for a business loan.