The Difference Between Fixed and Variable business loan Interest Rates: Which is Right for You
Fixed or floating? Which type of business loan interest rates should borrowers get for their businesses? It is one of the first questions loan seekers ask while approaching lending institutions to borrow business loans. The answer varies for each applicant, depending on their individual situation. Apart from the expected market fluctuations, a host of other factors are crucial in making the final decision, including the loan’s amortisation period, revenue stability, risk appetite, and growth prospects.
It is not possible to describe one form of interest as better than the other. Below, understand the differences between the two interest rate types and decide which is right for you. The final choice depends on the company's business, market view, and internal function.
Points of Difference Between Fixed and Floating Interest Rates
Fixed interest rates do not change over the financing term. Lending institutions set them based on bond yields in the market. Borrowers cannot repay fixed interest loans ahead of their repayment schedule without the loan provider’s permission, and they must pay prepayment charges if they do.
On the other hand, floating or variable interest rates vary over the repayment tenure based on the repo rate set by the central bank. In India, the Reserve Bank of India adjusts its repo rates depending on economic factors like the inflation rate. When they decrease or increase the repo rate, the floating interest rate generally moves with it to affect the business loan interest rate. In contrast to a fixed interest rate loan, borrowers can repay a floating interest rate loan in lump sum prepayments without paying any foreclosure charges.
Which Interest Rates are Higher – Fixed or Floating?
Fixed and floating interest rates are different because loan providers set them differently. Fixed interest rates are usually higher than floating rates, though they may vary based on economic conditions. Financial institutions charge a premium on fixed rate finance to cover the risk they take in the fixed interest rate. If the market rates increase, the market value of a fixed rate will decline and increase the lender's risk significantly. Borrowers use a business loan EMI calculator to decide their monthly EMI amount according to their repayment capacity. In comparison, floating term loans have less risk for loan companies because the borrower bears the risk of market fluctuations.
Choosing between a Fixed and Floating business loan Interest Rate
Business owners must consider several factors when choosing between a fixed or floating interest rate loan. Some of them are as follows:
· Market Conditions
The first question that comes to an applicant's mind is where they are in the interest cycle. The decision might result in overpaying on loan or saving a significant amount over the loan term. It often comes down to an aspiring borrower's market perspective. If they think rates might rise in the near future, fixing the rate would be better. If they feel the rates are at their peak, choosing a floating rate loan may decrease the cost over the loan term.
Foreseeing the ups and downs in the interest rates is foreseeable since central banks and economists usually discuss upcoming trends in advance. Market fluctuations do not take place in a vacuum. Consumers typically hear about them in advance, which is when they must start thinking about possible volatility in the interest rates. Getting caught off guard is the last thing one would want to do. Aspiring borrowers must keep an eye on the economy and decide which interest type is better for their lending horizon.
· Amortisation Period
The amortisation period is the length of time required to repay the loan. It can also affect an entrepreneur’s decision to choose a fixed or floating business loan interest rate. Generally, the longer the loan tenure, the more sense it makes to float even when the interest rate rises. Borrowers may pay a little higher for now but save money as the rates decrease over time. On the other hand, if they choose a fixed interest rate, they will be stuck with a high interest rate for the entire loan term. Choosing a fixed rate is better for a loan with a repayment term of fewer than five years, as the borrower will save money if the rates rise in the near future.
· Growth Prospects
Business owners expecting growth in margins or revenues are least concerned about the increasing business loan interest rate and prefer floating interest loans. Higher profits offset any rise in the interest rates, and a floating rate helps them take advantage of lower interest rates if they go down during the tenure. What’s more important for such entrepreneurs is a solid financial plan. It will allow borrowers to see how increasing interest rates may impact their working capital.
· Revenue Stability
A company with constant revenue can be better off with a fixed interest rate business loan. It enables the firm to turn variable costs into fixed ones, giving them a more stable picture of their finances. Choosing a fixed rate loan lets borrowers know their exact margins and predict profitability. If a company gets a fixed revenue for several years, it can predict its margin and choose a fixed rate loan for a longer amortisation schedule.
· Company Size
The company’s size is a crucial factor in deciding between a fixed and floating interest rate loan. Large-scale businesses often choose floating rate loans because they tend to get cheaper during the loan tenure. These companies have more scope to absorb the risk of increasing interest rates over time. On the other hand, small or medium-sized companies with tighter cash flow are more inclined to fix their interest rate to minimise the risk of surprise.
To summarise, fixed interest rates offer stability, while variable interest rates offer flexibility. The final choice for a business loan interest rate depends on where the business owner is leaning forward. It largely depends on the borrower and the company based on their cash flow, risk tolerance, and business goals.
