Fixed vs. Variable Loans: What’s the Difference?
by Fundid on Dec 22, 2021 1:24:00 PM
Financing is important for a small business. It can provide the business with funds to scale its growth or protect it in times when it is short on cash.
There are two typical types of funding that a company can engage in: a line of credit or fixed-term loan. A line of credit is used for emergency funding or to help with working capital needs, such as paying vendors or payroll. A fixed-term loan is typically used for purchasing large business assets, such as equipment or a new office.
Either of these loans can be attached to a fixed or variable interest rate.
What Is a Fixed-Rate Loan?
A fixed-rate loan is usually set for a specific period of time, typically six months to five years. It has a predetermined interest rate during the life of the loan, allowing a company to plan for set monthly payments that remain the same throughout the payback period. Payments are a combination of principal and interest.
Under a fixed-rate loan agreement, as long as the borrower continues to make payments on time and as agreed, the lender cannot demand repayment early. However, usually, the borrower may not pay off the loan early unless the lender agrees to it.
Paying off the loan early can result in significant penalties owed by the borrower that the lender uses to make up for the lost revenue it was expecting over the life of the loan.
The interest rate for a fixed-rate loan varies according to the borrower’s credit history, the type of loan that is received, and the classification of the lender. To qualify for a low-interest rate, borrowers must typically show the following:
Three years of business history
Revenue over $300,000 per year
A good credit score of at least 680
Borrowers with the best business and credit history will typically qualify for larger loans at lower interest rates. Commercial banks are typically able to provide a fixed-term loan with an interest rate between 2.5 and 7%, but they are hard to qualify for. Online lenders vary in their loan offerings. Interest rates from online lenders can vary from 7 to 99%.
FURTHER READING: A Business Owner's Guide to Business Loans
What Does Variable Rate Mean?
A variable rate loan has an interest rate that varies over time according to changes in the market. It is typically attached to a benchmark rate, such as the LIBOR (London Interbank Offered Rate) or the Prime Rate. Lenders then add a specific margin on top of the benchmark rate to accommodate their lending risk and other overhead costs.
Variable-rate loans do not have fixed monthly payments. Instead, the principal repayment amount remains the same, while the interest will vary from month to month, depending on what the benchmark rate is.
Variable-rate loans can be less expensive than fixed-rate loans, but there is the risk that interest rates could rise significantly, which would increase the monthly payment cost for the loan.
To qualify for a variable-interest-rate loan, borrowers must typically show:
At least one year of business history
Revenue of $180,000 per year
A credit score of at least 630
To mitigate the risk of potentially high-interest rates (and to lower the overall cost of borrowing), it is best to pay off variable-rate loans quickly if the business is able to. Variable-rate financing is usually attached to a line of credit loans but may be used for a fixed-term loan as well.
What Is an Interest Cap?
An interest cap is a limit on how high an interest rate can rise on variable rate debt. The cap can protect borrowers against substantial rate increases and provide a ceiling for maximum interest rate costs.
Usually, an interest cap is written into a loan contract at the borrower’s request. It can either limit the interest rate that can be charged each month, essentially “capping” the benchmark rate, or it can be set to limit the number of incremental changes in the rate of the loan.
While an interest cap can limit the amount of interest that is paid, it can still result in borrowers paying more than they had expected. Borrowers must be prepared to pay the maximum rate of interest indicated by the interest rate cap should the worst-case scenario occur and interest rates skyrocket.
What Is the Difference Between Fixed and Variable Rate Financing?
The main difference between variable and fixed-rate financing is the interest rate. As discussed, variable-rate financing has an interest rate that is attached to a benchmark, such as the Prime Rate or LIBOR.
A margin is applied on top of the benchmark rate to account for the lender’s risk and overhead expenses. Variable-rate financing can result in significantly higher monthly payments on a loan, especially if benchmark interest rates increase.
Another difference between variable and fixed-rate financing is the length of the loan. Variable-rate financing is often revolving, while fixed-rate financing generally has a set term during which the borrower must pay it off.
Advantages of a fixed-term loan include:
- Known monthly payments that can be planned over the life of the loan
- A fixed interest rate that does not change
Disadvantages of a fixed-term loan include:
- It may be more expensive than a variable interest loan
- Difficult to qualify for without appropriate business and credit history
Advantages of a variable rate loan include:
- It can be cheaper than a fixed-rate loan, especially if paid off early
- Easier to qualify for than a fixed-term loan
Disadvantages of a variable rate loan include:
- This can result in higher borrowing costs if interest rates rise
- Monthly payments will vary according to the current benchmark interest rate
When making the decision between fixed vs. variable loans, it's important to consider specific factors such as the current market interest rate trend, how quickly you plan to pay off the loan, and if you can manage regular monthly payments over the life of the loan.
Is a Small Business Loan a Variable or Fixed Rate?
Are small business loans fixed or variable?
A small business loan can be either fixed or variable, depending on its use. Loans that are fixed are usually used to purchase major business assets. They will give the borrower an upfront amount of capital, have a fixed interest rate, and offer a set payment term from six months to five years.
Variable-rate loans are typically used for working capital needs or as an emergency fund. They are usually structured as lines of credit or revolving credit. The borrower draws money on an as-needed basis, and interest rates vary according to changes in the market. There typically isn’t a specific repayment term.
What Is Better: Fixed Rate Loan or Variable?
When deciding which loan is better, fixed or variable, you should choose the one that best fits your company's needs.
For example, if your company is purchasing a new office and doesn’t have a lot of cash available, it would be more reasonable to choose a fixed-rate loan. Doing so allows the company to plan for the payments that will be due each month.
On the other hand, a business seeking a loan for emergency funding purposes would be better off with a variable-rate product that they can draw down as needed. A variable rate loan may be more expensive over the long term, so it is important that the company try to pay off any funds utilized quickly to mitigate interest costs.
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