Small business loans are among the most valuable resources for entrepreneurs looking to start or expand a business. With so many financing options to consider, how do you decide? Deciding between a fixed vs. variable interest rate loan is a good place to start.
In this article, we'll compare both options, explore their differences and help you determine when one might be better for your purposes.
What is an interest rate?
Before getting into how fixed interest rates vs. variable interest rates are different, let’s go over what interest is. Interest is the amount a lender charges you to borrow money. You’ll typically see it as an annual rate expressed as a percent.
How much interest you pay depends on how much you borrow. For example, taking out a $50,000 loan with a 10% interest rate costs roughly $5,000 in annual interest. But if you borrow $100,000? You’ll pay about $10,000 in interest for the year.
So, is a small business loan fixed or variable? It depends on your lender and the loan terms you choose.
Fixed loan rates
Fixed loan rates remain the same throughout the loan term. Because the interest rate doesn’t change, your monthly payments won’t change, making it easier to plan and budget your business finances.
Additionally, the consistent payment structure of fixed business loan interest rates can give you peace of mind by having more stability in your cash flow.
Example of a fixed rate business loan
Samantha owns a fitness studio and wants a $100,000 loan to open a second location. She qualifies for a small business loan with a fixed interest rate of 13%. Samantha will pay the same interest rate until she pays off the loan, and her monthly payments will be the same amount each month.
A fixed interest rate makes it easier for her to budget her expenses because she knows exactly how much her monthly payments will be. She can also relax about her repayment schedule because her interest rate won’t increase over the life of the loan.
Fixed loan interest rate pros and cons
Pros:
- Consistency and reliability in monthly payments
- Safeguard against interest rate increases
- Clear terms that are easy to understand
Cons:
- Potentially higher interest rates
- No benefit from interest rate decreases
- Potential penalties for early repayment
Variable loan rates
A variable rate loan is a type of small business loan where your interest rate can change depending on market conditions. The small business loan interest rates for variable loans typically start lower than the interest rate on a fixed business loan, but they can go up or down over time.
Variable loan rates could cost more than you planned if the rate goes up during your loan term. However, the loan terms typically limit how much it can fluctuate from one period to the next.
Example of a variable rate business loan
John owns a small retail store and needs to borrow $20,000 to purchase inventory. He researches lenders and determines a variable rate loan is best for his situation. The lender sets the interest rate based on the prime rate plus a margin. The prime rate is currently 8%, and the lender charges a margin of 2%, making John’s initial interest rate 10%.
If the prime rate goes up to 9%, John’s interest rate will increase to 11% — and his monthly payment will also increase. On the other hand, if the prime rate drops to 6%, his interest rate will decrease to 8%, and his monthly payments will also go down.
Variable loan interest rate pros and cons
Pros:
- Initial lower interest rate
- Potential cost savings if the rate remains low or decreases over time
- Ideal for short-term borrowing needs
Cons:
- Monthly payments could become unaffordable
- Risk of interest rate hikes
- No control over loan costs
Which small business loan is better: Fixed vs. variable interest?
Whether a fixed vs. variable interest rate loan is best to fund your small business isn’t always an easy decision. It comes down to your business needs, financial situation and risk tolerance.
A fixed interest rate may be the better option if you value stability and predictability. This is particularly true if you have a limited budget and must carefully manage your cash flow.
Choosing a variable interest rate may make sense if you’re comfortable with some uncertainty in exchange for potential interest savings. It may also be a good choice if you expect interest rates to go down or are looking for a short-term loan.
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