Benefits of a variable rate

How Variable Rate Could Positively Impact Your Bottom Line

In a much-anticipated move, the Federal Reserve raised rates for the first time since 2018 on March 16, 2022. While this increase was expected, the Fed signaled several more interest rate hikes this year. We’re breaking down what this could mean for our small business customers, and why choosing a variable rate could be beneficial.

 

History of Prime Rate

Prime rate is a financial benchmark used by banks to determine interest rates, and often serves as a starting point for lenders. Prime rate can fluctuate depending on economic factors and shifts along with interest rates set by the Federal Reserve. The Federal Reserve, the central banking system of the U.S, uses interest rate (also known as federal funds rate) as its main tool to manage inflation. As a rule of thumb, the Fed can increase the fed funds rate as a response to temper rising inflation, which means Prime will go up too. On the other hand, when inflation is falling and economic activity slows, the Fed can lower the fed funds rate to encourage economic growth. This is helpful context when it comes to understanding interest rates and their tendency to fluctuate over time. In March of 2022, the Fed raised the rate by 25 basis points for the first time in three years, followed by a corresponding hike in Prime.

While the casual observer may worry about the implications of rising rates, it’s important to look at the historical rate trends to understand where we sit today.

BJ Losch, Live Oak Bank’s chief financial officer, sheds light on the matter, “Only 24 months ago, just before the onset of the pandemic, the Prime rate was at 4.75%. In fact, the Fed had raised rates such that Prime was actually 5.50% in December of 2018 before cutting rates three times over the course of 2019 to try and stimulate economic growth and – ironically – higher inflation.”

While technically we are in a rising interest rate environment, rates are still historically low. According to Losch, “Over the course of US economic history going back 60 years, the average Fed Funds rate is ~4%, and the Prime Rate is ~7%, 200 basis points higher than what is projected by the end of 2022.”

 

Below: the effective federal funds rate from 1954.

Effective Federal Funds Rate

Source: FRED

 

Losch references Harvard economist and former Chair of the White House Council of Economic Advisors Jason Furman who said, “The era of super-duper low interest rates is coming to an end, but we may (still) be in the era of super low interest rates for a while.”

So how do these shifts impact Live Oak’s perspective on lending, and how does that affect our loan customers? Let’s take a deeper look at fixed versus variable rates.

 

Debunking the Myth that Fixed Rate is Better

With the federal funds rate remaining below its historic average for the past 16 years, rates remain cheap when compared to recent history. A common (and often incorrect) assumption is that fixed rates are better because it offers stability and predictability around monthly payments. However, quite often, the rate for variable rate loans is lower than a fixed rate. In addition, if your loan has mortgage-style amortization, you are paying a higher amount of interest monthly at the onset of the loan.

A borrower’s initial rate may change over time, but it could often start out low enough to counteract any rise in rates. If the base rate goes down, borrowers could enjoy lower monthly payments and won’t be locked into a single rate, like the fixed rate approach.

If we look at the trends throughout the last several decades, interest rates ebb and flow. Many times, a compelling variable rate offer can be as good or better than fixed rate offers.

Another way to look at it — a fixed rate is priced differently because the bank is taking on more risk. The rate that a lender charges to fix a loan is going to be indicative of what’s happening in the market. Essentially, banks must be compensated appropriately for the elevated risk of fixed rate pricing.

While the Fed has suggested there will be several more rate hikes over the course of 2022, rates are still historically low. Better yet, as history has shown us, what goes up must come down — including interest rates, which is why it a variable rate could be a good option.

 

Let Us Be Your Guide

The experienced loan team at Live Oak can help our borrowers navigate their options and ensure that they fully understand how a variable rate could ultimately benefit their bottom line. Connect with us to learn more about opportunities for small business capital.