Anticipated inflation rates drive interest rates. With debt as prevalent as it is with consumers and businesses, what is the impact of inflation on business loans?
Up until a few months ago, we hardly ever heard about inflation. Fast forward to today and not only is it front-page news every other day, but we come face-to-face with it every time we buy something at the grocery store, or gas pump, and everywhere in between. As a result, many current and prospective business owners are trying to figure out the impact of inflation on business loans.
When inflation first reared its ugly head, we were told that it was only going to be transitory, or here for a short time. However, it is looking like it is going to be with us for much longer.
Most American households and businesses carry some form of debt, whether it be mortgage debt, tuition debt, credit card debt, or business debt, The interest paid on every single form of debt is in large part determined by expected inflation rates. As a result, inflation rates, particularly expected inflation rates play a very big role in the setting of interest rates.
This begs the question, what is inflation and specifically, what impact does it have on money that I borrow?
What is inflation?
Inflation occurs when prices rise, resulting in a decrease in the purchasing power of your money. For those on a fixed income, inflation can be a bad thing because the quantity of goods and services you can buy with your income will decrease, while your income will remain the same. While this is a bad thing, many economists agree that modest and stable inflation is necessary for a healthy economy because it stimulates individuals and businesses to spend their money, rather than ‘park it’ in a savings account.
What impact does inflation have on money I have borrowed?
Generally speaking, two things pertaining to inflation will affect your loan. First, whether or not you have a variable-rate or fixed-rate loan. Second, is the inflation rate.
Fixed Interest Rates: An Overview
With a fixed-rate loan, you pay the same amount each month, regardless of prevailing interest rates or the inflation rate for the duration of the loan. In other words, the interest you pay is fixed over the life of your loan. You also know how much your loan payment will be until your loan is paid off. Additionally, with a fixed-rate loan, the lender assumes the interest rate risk, the potential for losses as a result of changes in interest rates.
Variable Interest Rates: An Overview
In contrast, a variable-rate loan has an interest rate that fluctuates based on market developments and current interest rates, in most cases, the prime rate, which is based in part on the Federal Reserve’s federal funds rate. In other words, the interest you pay changes over the life of your loan in response to changes in prevailing interest rates. As a result, you the borrower assumes the interest rate risk.
What happens with fixed-rate loans in an inflationary period?
As inflation increases, so do underlying interest rates. With fixed-rate financing, you are paying back your loan with money with less purchasing power than what you borrowed. Additionally, you are paying interest on your loan that is less than prevailing interest rates.
During periods of high inflation, wages and revenues may rise. If you earn more money but keep your monthly financing obligations the same, your payments will make up a smaller amount of your working capital.
Keep in mind that your loan can go the other way as well. As inflation falls, so do interest rates. If you have a fixed rate loan, you may end up paying money borrowed at an interest rate greater than prevailing interest rates. As a result, the interest rate on your fixed-rate loan or lease may not be as attractive as when you first took out your loan.
What happens with variable-rate loans in an inflationary period?
With a variable-rate loan, the interest rate increases or decreases with prevailing interest rates. Any decrease in purchasing power on the money borrowed will be offset by any increase in the interest rate, and vice versa. As a result, a variable-rate loan does not offer the same advantage of a fixed-rate loan to the borrower in an era of increasing inflation.
What is the best interest rate option for business equipment loans?
Between the two types of loans, we prefer fixed-rate business equipment loans because we believe that knowing the exact amount of your monthly payments as well as how much your financing will cost you throughout the life of the loan gives you peace of mind and the ability to prepare ahead. Additionally, future interest and inflation rates are very difficult to predict. As a result, it is not a good idea to base the type of loan you get on what direction you think interest and inflation rates will go. However, we provide only fixed-rate equipment loans because we believe that they are the best option for the vast majority of our clients.
If you are looking for an equipment loan to purchase new tools and equipment for your business, contact us or call (800) 795-3919 to discuss the best course of action today. With that, hopefully we have answered the question “what is the impact of inflation on business loans?