What every SME owner needs to know about interest rates and the cost of borrowing

February 29, 2024

As a small or medium-sized enterprise (SME) owner, you’ll know that successful navigation of the financial landscape, especially during challenging economic times, is crucial. 

A key feature of this landscape – one that demands your attention – is the domain of interest rates and borrowing costs. Indeed, understanding the technicalities of both can be the difference between thriving and merely surviving.

In this blog, we explore the mechanics of interest rates, how they affect the cost of borrowing, share strategies for managing tough economic times, and look at the current state of play in the UK and U.S.

Interest rates: The pulse of the economy

Interest rates are set by the Bank of England in the UK, while, in the U.S, the authority to set interest rates is shared between the Board of Governors of the Federal Reserve (Board) and the Federal Open Market Committee (FOMC).

Serving as the economy's pulse, interest rates influence borrowing costs across the board. For SMEs, they determine the cost of loans and credit lines that are so vital for business growth and operational stability.

When interest rates rise, as they often do in response to inflation or economic recovery, the cost of borrowing increases, squeezing your cashflow and making loans more expensive. 

By contrast, low interest rates often serve as a boon, making borrowing more affordable, fostering investments, and stimulating business expansion.

The impact of interest rates also extends beyond direct borrowing costs. Not only do they influence consumer spending and the demand for your products or services, but higher rates may lead to reduced consumer spending, impacting your sales. It's a delicate balance that SMEs must navigate.

When considering loans, you'll encounter fixed and variable interest rates. 

Whereas fixed rates remain constant over the loan period, offering predictability in repayments, variable rates are a little more complex. In the UK, they’re tied to the Bank of England's base rate, while in the U.S., they’re tied to a range of index rates, including Treasury Bill Rates and the Secured Overnight Financing Rate (SOFR). In both countries, variable interest rates are prone to fluctuation, posing a risk of higher payments if rates rise. 

Each has its merits; the choice depends on your risk tolerance and financial outlook.

The cost of borrowing

Borrowing costs comprise more than just interest rates, encompassing arrangement fees, repayment terms, and penalties for early repayment. 

Understanding the total cost of borrowing is essential, ensuring it aligns with your business plan and cashflow projections.

Below are some strategies you can use to mitigate the cost of borrowing when factors outside of your control see a rise:

Budget for higher costs: In times of rising interest rates, adjust your budget to account for increased loan costs. This foresight helps maintain financial stability.

Seek fixed-rate options: If predictability is critical for your business, consider fixed-rate loans to shield against rate fluctuations.

Explore alternative financing: Beyond traditional bank loans, explore other financing options like government grants, invoice financing, or revenue-based financing, which can offer more favourable terms.

Strength your financial health: Improve your credit rating by maintaining a strong balance sheet and timely debt repayments. A better credit score will often lead to providers offering better terms on loan facilities.

Consult financial experts: Don't hesitate to seek advice from financial advisors – they can offer tailored strategies suitable for your business's specific needs and goals.

Navigating current interest rates and borrowing costs

In the U.S., as of November 2023, the Federal Funds Effective Rate sits at 5.33% and marks a rise from the fallout of the 2008 financial crash.

As of the end of 2023, the Bank of England's base rate stands at a comparable 5.25%, a significant increase from the historic low of 0.1% during the COVID-19 pandemic and the highest rate since 2008.

This hike in base rates has profound implications for SMEs. As explained above, higher interest rates can lead to increased borrowing costs, affecting existing loans and new financial commitments – but also affecting the cost of goods and services, as suppliers have to hike their prices to manage their own overheads. 

As such, navigating the current economic reality requires you to take a strategic approach to financial planning and debt management.

The impact on SME borrowing

Lately, the borrowing landscape for SMEs has seen notable changes. In June 2023, the annual growth rate of borrowing by UK SMEs decreased by 4.2% compared with the previous year. This downturn from -4.3% in May 2023 indicates a cautious approach in the SME sector toward borrowing amid rising interest rates.

For U.S. businesses, the business debt-to-GDP ratio and gross leverage – the measure used to assess the degree to which a company uses debt to finance its operations – both remain at high levels. Moreover, the ability of risky borrowers to service their debt burdens has begun to show signs of weakness, as is common in a rising interest rate environment.

Implications for SME owners

The figures above underscore how important it is for SMEs to exercise financial management. The current interest rate environment necessitates a careful evaluation of borrowing needs and the potential impacts of rate fluctuations on business finances. 

It's therefore crucial to assess the cost-effectiveness of loans and consider alternative funding sources where appropriate.

Final thought

If you’re an SME owner, a thorough understanding of interest rates and borrowing costs is not just about managing debt – it's about making informed decisions that fuel growth and resilience. 

As the economic landscape evolves, staying informed and adaptable is key to steering through these turbulent financial waters in one piece.