Interest Rates and Small Businesses: What You Need to Know

Last Updated September 20, 2024

Interest rates have been a hot topic of conversation for small businesses over the past year after the federal funds rate hit a 23-year high in July 2023.

The Fed rate had then remained steady (5.25% – 5.50%) until a September 2024 decision to cut rates by a half point, a significant reduction. However, questions still remain surrounding the impact of interest rates on small businesses. How does the current rate affect small business owners, and what should they do and be cognizant of when rates change?

What Are Fed Rates?

The federal funds rate (or Fed rate) is the target interest rate for commercial banks to borrow at. This rate is set by the Federal Open Market Committee (FOMC), which meets several times a year to evaluate and determine the target Fed rate.

This federal interest rate has impacts across the economy, including the cost of borrowing for both consumers and businesses. Generally speaking, the Fed rate is increased when the FOMC wants to slow down spending and reduce inflation, and the rate is dropped to stimulate the economy.

Effects of High Interest Rates on Businesses

In June 2024, the federal interest rate was the highest it had been in over 20 years after consistent rate hikes throughout the previous four years. And while the Fed cut rates by half-a-percent in September 2024, small businesses are still reeling from the financial challenges of the high interest rates.

Here’s a look at how these high rates have affected small businesses.

More Expensive Borrowing

One of the biggest negative effects of high interest rates on small businesses is the cost of borrowing. As the Fed rate increases, so does the interest that business owners pay on loans and lines of credit as lenders charge a premium for borrowed funds. Because of this increased cost, some business owners may delay taking out a loan or may spend more money repaying lenders, limiting business growth.

Despite the current high interest rates, a NerdWallet survey found that 67% of small business owners in the US plan to seek funding in the next 12 months, potentially due to the hope that rates will fall later this year.

Less Cash Flow

The cost of borrowing isn’t just more expensive for businesses when interest rates rise – consumers feel it as well. With higher payments on car loans, mortgages, and student loans, consumer spending slows, which leads to less shopping at small businesses across the country. Additionally, during an economic slowdown, business spending decreases, so B2C and B2B businesses alike feel this dip in revenue.

As spending slows, it’s important to properly manage your cash flow so that you don’t get stuck in a cycle of negative cash flow that you can’t get out of. Properly managing your debt repayments, re-evaluating your pricing structure, and negotiating better payment terms can all help you improve cash flow during an economic downturn.

Slower Business Growth

Higher rates lead to lower consumer spending and less accessible borrowing, which can result in limited business growth. With less spending and a slower economy, cash can become tight, making it more difficult to invest in expansion opportunities.

Robert Farrington, a finance expert and founder of The College Investor, explains, “Interest rates can play a big role in small business finances, especially those who rely on a line of credit or borrowing to get the equipment or space they need.” If a business owner was planning to take out a loan to finance expansion, those plans may be delayed until interest rates are lower.

Slower Debt Repayment

Because commercial interest rates increase during a rate hike, it can take more time to pay off your existing loans. As you are forced to allocate more cash to debt repayment, other areas of your business may suffer, such as your plans to purchase more equipment or hire more employees.

Effects of Low Interest Rates on Businesses

Even though interest rates are currently high, the federal funds rate is expected to continue to lower as the economy slows. As this happens, it’s important to keep in mind the effects that low interest rates will have on small businesses.

More Affordable Borrowing

Because a lower Fed rate makes borrowing cheaper for consumers and businesses alike, accessing loans, lines of credit, and other lending products will be much easier. With more affordable borrowing, business owners will have the means to further invest in their companies, such as opening another retail location, purchasing necessary equipment to increase operations, or expanding their marketing budgets to drive more sales.

Increased Sales

When the FOMC lowers the Fed rate, it’s largely to stimulate the economy and boost spending. Lower rates lead to more consumers having disposable income, which can lead to more sales for your small business, if you are a B2C company.

The increased purchasing behavior isn’t limited to just consumer-facing businesses, though. B2B companies can see similar revenue and profit improvements as an active economy has positive impacts throughout the market and supply chain. As the economy is stimulated, business spending increases as well.

Cheaper to Pay Off Debt

Similar to how it is more affordable to access borrowing when rates are lower, the cost of paying off debt is cheaper as well. With lower interest rates, business owners can put more money towards the principal and less towards the interest, helping them lower their debt more quickly and use the savings to invest in other areas of the business.

Tips for Small Business Owners Concerned About Interest Rates

Small business owners are typically most concerned about interest rates when they are high because this causes the cost of debt to rise and makes running a business more expensive in general. And despite the most recent cut, rates are still high compared to historical averages.

Gates Little, President of the Southern Bank Company, acknowledged that any shift in rates could have a significant impact on small businesses.

“The latest move by the Federal Reserve to lower rates should help small businesses by spurring growth in the economy. It may also lower the cost of debt,” Little said. “On the other hand, a growing economy often increases job demand, giving us higher wages, and then higher prices. If I had to guess, small business owners know all of this firsthand and are pleased with the move.”

Below are some other tips for business owners who might be affected by interest rates.

Improve Cash Flow Management

Because interest rates can greatly impact the financial health of businesses, cash flow management is needed to secure your company’s financial future. While cash flow is important during cycles of low and high interest rates, it will likely feel more pressing to improve your cash flow during times of rate hikes.

There are several ways that you can improve your business’s cash flow, such as:

• Restructuring your pricing
• Shortening the invoice payment terms that you offer other businesses
• Charging late payment fees
• Reducing your inventory
• Improving customer credit check processes
• Negotiating better terms with vendors
• Factoring your invoices

Review Customer Creditworthiness

A great way to protect your business from non-payment is by performing credit checks on your customers. Before extending credit to your clients, it’s important to evaluate:

• Their payment history
• Their business credit profile
• Their profitability over time

By evaluating new clients before working with them and offering them terms, you can reduce the risk of fraud, late payments, and non-payment, helping improve your overall cash flow and protect your business during times of economic uncertainty.

Evaluate Debtor Concentration

Debtor concentration refers to the distribution of accounts receivable owed across your debtors (or customers). For example, if all of your outstanding accounts receivable is owed by one debtor, your debtor concentration would be 100%, but if half of your accounts receivable is owed by one debtor and the other half is owed by another debtor, then each debtor would have a concentration of 50%.

By evaluating your debtor concentration, you can focus on reducing the risk that you take on when extending credit to your customers, which can help protect your business during times when interest rates are high, borrowing is expensive, and cash flow is tight. By diversifying your customer portfolio and shrinking your debtor concentration, you reduce your own financial risk.

Consider Your Financing Options

Acquiring financing can be difficult when interest rates are high, and it’s normal for business owners to be concerned about accessing business funding. In fact, 17% of small business owners are concerned about being rejected for the financing they need in the next 12 months.

To help reduce your concern about receiving funding, it’s important to understand the options that you have available. For example, while business loans and lines of credit are easier to access when interest rates are low, they can come at quite the premium when rates are high. If that’s the case, it may be helpful to explore alternative financing options, such as invoice factoring or peer-to-peer lending.

September 2024 Update: Fed Cuts Interest Rates for the First Time Since 2020

In September 2024, the Federal Reserve announced interest rates would be cut by 0.50%, now fluctuating between 4.75-5.00%. This marks the first time since March 2020 rates were lowered.

This substantial reduction could be making up for the high rates holding steady at their previous meeting in July 2024, a period when some experts believed rates should have been lowered.

Federal Reserve Chair Jerome Powell reminded citizens that they shouldn’t expect cuts to be as substantial moving forward, but that economic trends are positive.

“The U.S. economy is in good shape, growing at a solid pace. Inflation is coming down,” Powell said. “Though I do not think that anyone should look at this and say, ‘Oh, this is the new pace.”

For small business owners, this likely means generally slightly easier access to credit moving forward. This is welcomed news, as borrowing has been notoriously difficult given the record-high rates over the past few years.

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Interest Rates and Small Businesses FAQs

Who benefits from higher interest rates?

Financial institutions are most likely to benefit from higher interest rates. They will typically charge a higher premium than they pay on deposits, resulting in increased earnings.

Are interest rates rising?

The federal funds rate is falling as of the most recent update in September 2024, when rates dropped by half a point. This was the first time rates dropped after a 4-year period between March 2020 – July 2024 where they continually increased.

Do businesses make more money when interest rates rise?

While there will be no answer that is applicable to all businesses, typically companies see a drop in consumer and business spending when interest rates are high, resulting in lower revenue. However, this is a wide-sweeping statement and by no means true for all businesses.