It’s no secret that starting up your own business can be difficult, especially if you don’t have any money to put into it right away. You may want to consider obtaining a small business loan, which lets you borrow money from the bank and pay it back with interest over time.
Banks or other financial institutions typically provide small business loans, but you may also be able to apply for funding from alternative sources like family and friends, crowdfunding sites, and peer-to-peer lending sites (although this isn’t recommended).
In terms of loan terms, you have two choices: fixed or variable-rate loans. A fixed-rate loan means the interest rate stays the same over the life of the loan, whereas a variable-rate loan starts at one interest rate, then adjusts periodically based on market conditions and economic factors.
The primary difference between these two types of loans is how much interest you’ll be charged on your loan and whether that interest rate will change over time. This article will help you understand the differences between these two types of small business loans so you can choose the right loan option to meet your needs.
What is A Fixed Loan?
A fixed loan is a type of small business loan that is repaid in equal monthly payments over the life of the loan. The interest rate on a fixed loan is set at the time the loan is originated, so you know exactly how much your monthly payments will be.
This makes budgeting for your loan repayment easy and predictable. Fixed loans are often used by borrowers who want to minimize their risk because they have other sources of income besides their small businesses.
The only downside of fixed loans is that they tend to be more expensive than an adjustable-rate or short-term loans. Fixed loans charge higher interest rates because lenders can assume you will be able to keep your business afloat and make payments for up to 10 years.
Lenders know that if your business fails, you may not be able to repay them within a short time frame. They want their money back, so they set a higher interest rate than on other types of small business loans.
Pros and Cons of Fixed Rate Business Loans
Pros
Fixed-rate business loans offer many advantages for small businesses. With a fixed rate, your interest payments will be the same each month, making budgeting easier. You’ll also know exactly how much you’ll need to repay each month, so you can better plan your cash flow.
In addition, fixed-rate loans can offer lower interest rates than variable-rate loans, helping you save money over the life of the loan. For example, if you’re considering an SBA 7(A) loan, your rate will be either prime + 2% or 5%.
In addition, if you secure your funding with U.S. Treasury Bonds as collateral through FASBO, interest rates can be as low as 1%. And there are other advantages of fixed-rate loans for small business owners. Most don’t require collateral and have flexible repayment terms that may match your cash flow needs; lenders like SBA also offer long-term payment options with no prepayment penalties.
Cons
Small businesses have a few disadvantages when it comes to taking out fixed-rate business loans. For one, the interest rates are often higher than variable-rate loans. This means that you’ll end up paying more in interest over the life of the loan.
Additionally, if market rates drop after you take out your loan, you’ll be stuck paying the higher rate. Plus, if you need to refinance your loan down the road, you may not be able to get as good of a term as you originally had.
However, with some of these loans, you may be able to get your interest rate adjusted or even eliminated if certain conditions are met. For example, if your business has experienced some hardship—like a flood damaging your building—you might qualify for an economic hardship deferment that would eliminate or reduce your interest payments. This isn’t guaranteed, though. It’s important to always read through any fine print before signing on the dotted line.
What is A Variable Loan?
A variable loan for a small business is a loan in which the interest rate may fluctuate over the life of the loan. Variable rates are often tied to an index, such as the prime rate. This means that when the index rate changes, so does your interest rate. Variable rates can start out lower than fixed rates, but they may increase over time, which could end up costing you more in interest.
The lower initial rate may seem appealing, but there are risks involved with variable interest rates. Because they can change in line with economic factors, you don’t know exactly how much your monthly payments will be.
If a variable interest rate rises over time, it could become more expensive than a fixed-rate loan. In addition to that, if you want to refinance your small business loan to take advantage of a lower fixed-rate option, you may not be able to do so unless you have an in-school status.
Pros and Cons of Variable Rate Business Loans
Pros
One of the benefits of variable loans for small businesses is that they offer more flexibility than fixed loans. With a variable loan, you can change your repayment schedule if your income fluctuates.
This can help you avoid defaulting on your loan and damaging your credit score. Additionally, variable loans often have lower interest rates than fixed loans, which can save you money over the life of the loan. Another advantage of variable loans is that they can be used for various purposes, such as business expansion or inventory purchases.
Plus, if you plan on selling your business in the future, a variable loan can be paid off more quickly than a fixed loan, making the sale process simpler.
Cons
One of the main disadvantages of variable loans for small businesses is that they can be quite unpredictable.
You may think you have a handle on your finances, but if the interest rate increases, your monthly payments could go up significantly and put a strain on your budget. Additionally, variable loans typically have shorter terms than fixed loans, so you’ll need to be prepared to make higher monthly payments.
This can be difficult for small businesses that are just starting and may not have a lot of extra cash on hand. If you default on a variable loan, the lender may require that you immediately pay off the entire loan, which can be difficult to do if you’re already struggling financially.
It’s also worth noting that some lenders will convert variable loans into fixed ones in certain circumstances. For example, if you stop making payments and don’t communicate with the lender.
Differences Between a Fixed and Variable Loan
The biggest difference between fixed and variable business loans is the interest rate. A fixed loan has a set interest rate that will remain the same for the life of the loan. On the other hand, a variable loan has an interest rate that can fluctuate over time.
Variable business loans are great for borrowers who want to keep their interest rates low, but there are some trade-offs. Sometimes, these loans can cost more than fixed-rate loans since you’ll have to pay more if rates go up.
Since variable business loans will be tied to an index like the Secured Overnight Financing Rate (SOFR), which measures interest rates on interbank lending, your monthly payments could rise and fall dramatically depending on how much banks charge each other for short-term borrowing. That means your credit standing may not matter as much as it would with a fixed loan.
The good news is that most lenders will review your personal credit history, your business’s current cash flow, and future projections when deciding whether to approve you for a loan. This means that if you have a bad credit score, it might not matter too much if you have a great business idea.
What matters most is that you can show lenders evidence of stable finances and ongoing profits so they feel confident extending money to you. As long as your business continues to grow and make money, then it should be able to handle interest rate fluctuations over time.
Reasons Why a Small Business May opt For a Fixed or Variable Loan
- Before starting a small business, you should have a good idea of what type of loan you will need to finance your company and why you will need it in the first place. While most loans are available at fixed or variable rates, there are reasons to opt for one over the other. Here are some reasons why businesses opt for either fixed or variable loans.
- With a fixed loan, you’ll have predictable monthly payments, making budgeting easier. However, with a variable loan, your payments may be lower initially but could increase over time.
- A fixed loan may be a good option if you know exactly how much you’ll need to pay each month.
- A variable loan may be a good option if you’re comfortable with some uncertainty and want the potential for lower payments.
- Ultimately, the best option for your business will depend on your specific needs and circumstances. Talk to your lender if you want more information about fixed versus variable loans.
Recommendations For Small Businesses from American Business Credit Before Deciding on a Loan
There are many reasons why a small business might opt for a fixed or variable loan. However, before making any decisions, it’s important to seek out recommendations from financial advisors like the American Business Credit. After all, they have the experience and expertise to help you get the right kind of loan in the long run.
At American Business Credit, we will tell you if your current credit score is good enough to qualify for loans and, if not, how you can improve your credit score over time. With our knowledge and guidance, it should be easier than ever to get a loan when you need one most. Here are seven reasons why.
- Decide what type of loan you need.
- Shop around for the best rates and terms.
- Find a lender you trust.
- Read the fine print and ask questions about anything you don’t understand.
- Choose a loan that’s right for your business, not just one with the lowest interest rate.
- Be prepared to repay your loan on time and in full.
- Keep good records of your payments to help build your business credit history.
