The Reality of Interest Rate Increases

The Federal Reserve raised the federal funds interest rate by 25 basis points in March 2022, and more increases are expected. It’s predicted the Fed will raise rates by 50 basis points—or a half percentage point—at each of its next two meetings in May and June. What is the reality of rate increases for business owners?

First, here’s the 101 behind Fed rate increases. The federal funds rate is the interest rate banks charge each other for overnight loans. The Federal Reserve’s Open Market Committee determines the federal funds rate. Fed rate hikes increase banks’ cost of funds. Ultimately, banks pass along the increases to their customers through all types of loans including home mortgage, auto, and commercial loans. 

Given the current economic climate and level of inflation, the Fed is in a position to use a critical tool – interest rate increases – to fight inflation. It’s a lever the Fed has used successfully in the past in efforts to control inflation or deflation. In the 1980s, the Fed funds rate reached a high of 20% to combat double digit inflation. Decades later the Fed twice lowered the rate to a range of 0% to .25% to control for deflation. The first time was during the financial crisis of 2008. The Fed didn’t raise rates again until December 2015 and then in March 2020 when the Covid pandemic started.

The current interest rate conversations have been ongoing for several months given the indications of inflation in our economy. The Russia-Ukraine conflict added a layer of complexity to the strategic discussions and rate decision. In a meeting with Congress’ committee on banking in early March, Fed Chair Pro Tempore Powell told lawmakers, “The near-term effects on the US economy of the invasion of Ukraine, the ongoing war, the sanctions, and of events to come, remain highly uncertain. Given the current situation, we need to move carefully.”

Second, let’s examine what rate increases mean for business owners – starting with defining basis point for owners unfamiliar with the term. It represents the smallest unit of measurement for interest rates and other financial instruments. One basis point is equal to one-hundredth of %, or .01, which means 100 basis points is equal to 1%.

The Federal Reserve Board increased the rate by 25 basis points on March 16, which means the federal funds rate increased from 0.25% to 0.5%. Interest rates were at historic lows. Chairman Powell has said the Fed will be “humble and nimble” navigating the situation and risks while using data and communicating transparently. Raising the Fed funds rate by 25 basis points had an immediate impact.

To put it into perspective, apply the increase to a 10-year loan of $250,000. Increasing the interest rate from 3.25% to 3.5% makes the monthly payment go from $2,339.73 to $2,356.75, or $17.02 higher per payment, which is an additional $2,042.40 in interest over the life of the loan.

Owners who have long-term growth plans should not stop acquisitions and expansions. Reviewing the decades of history related to interest rates shows since the 1980s, rates have decreased overall and been favorable for the business sector. The economic climate continues to be robust and healthy.

• Owners should continue moving business strategy forward. The economy remains robust with low unemployment. Discuss financing related to your business plan with your lending partner. Navigate decisions based on thoughtful long-term forecasts. Take advantage of this historic low interest rate environment.

• Weigh the options of a variable or fixed rate loan. A short-term loan should not be as worrisome as considering a long-term loan deal. Remember, refinancing in the future is always an option.

• Match your liabilities with your assets. Generally, long-term assets should be financed with long-term liabilities. Short-term assets should be financed with short-term liabilities. Weigh your ability to absorb future interest rate increases and your ability to pass along price increases.

• Talk with lenders about your business and assess market dynamics to contemplate how it could be impacted by the overall market, not just rate increases. For example, our team works with travel insurance companies. It’s been a hard business over the past two years. Decisions related to financing are very different for these customers than traditional insurance agents who cover auto, home, renters, and other lines.

The current economic market is in a historically unprecedented space. A global pandemic, supply chain challenges, the Great Resignation and Russia-Ukraine escalation are not in our control. Use the recommendations above to control what you can to continue strategic and performance driven business expansion and growth.

Rick Dennen is the founder, president & CEO of Indianapolis-based Oak Street Funding, a First Financial Bank company with customized loan products and services for specialty lines of business including certified public accountants, registered investment advisors and insurance agents nationwide.