One of the most important factors to consider when applying for a small business loan is the interest rate. The lender may offer a fixed or variable rate and the one you choose directly affects how much the loan actually costs over the long-term.

Variable interest rates are also associated with business credit cards, which can boost your spending power while allowing you to earn some valuable rewards in the process. If you’re considering applying for a business credit card or a small business term loan, this guide explains everything you need to know about variable interest rates.

How a Variable Interest Rate Works

A fixed interest rate is just that–once the rate is set by the lender, it doesn’t change. A variable rate, on the other hand, can increase or decrease over time.

Variable interest rates are tied to an index or benchmark rate, such as the prime rate. The prime rate is a short-term interest rate that’s determined by the federal funds rate, which is set by the Federal Reserve. When the prime rate is adjusted upward, variable rates also rise. Conversely, when the prime rate goes down, variable rates decline.

While the Federal Reserve increased the federal funds rate by 0.25% in December 2015, interest rates remain near historic lows. That’s excellent news for business owners who are in need of capital to finance an equipment purchase, expand their operations or cover a temporary cash flow crunch.

How a Variable Rate Benefits Borrowers

Choosing a term loan or credit card with a variable rate has the potential to save your business money over time. Variable rate loans tend to have a lower starting point than their fixed rate counterparts. For example, a lender may offer fixed rate term loans beginning at 6% but drop the rate to 4.99% if you accept a variable rate instead.

If you’re able to lock in a lower variable rate on a loan and there are no significant changes in the prime rate, you may pay less in interest than you would if you opted for a fixed rate instead. Here’s an example to illustrate the potential savings to your business by choosing a variable rate:

Loan A

  • Loan amount: $50,000
  • Loan term: 3 years
  • Interest rate: 4.99% variable rate
  • Monthly payment: $1,498.32
  • Total interest paid: $3,939.53

Loan B

  • Loan amount: $50,000
  • Loan term: 3 years
  • Interest rate: 6% fixed rate
  • Monthly payment: $1,521.10
  • Total interest paid: $4,759.49

While you see there’s only a slight difference in the monthly payment amount, the fixed rate loan would save you nearly $820 in interest, assuming the variable rate doesn’t rise.

What Business Owners Must Consider

The potential savings associated with a variable interest rate is certainly attractive but there are two distinct dangers to be aware of. First, there’s the possibility that your payment could substantially increase if your rate were to go up. A jump of several hundred dollars in your monthly payments may leave your business stretched thin financially if you’re unprepared.

The other pitfall is the risk of paying more in interest on what you borrow if your rate were to increase. The longer your loan term, the greater the odds of a variable rate rising at some point. If the rate remains higher, the cost of borrowing is likely to exceed that of a fixed rate loan.

Who Should Consider a Variable Interest Rate?

A variable interest rate may be a suitable choice for business owners who are borrowing smaller amounts and are in a position to pay the loan off relatively quickly. This type of rate is also better for businesses that have a steady flow of cash coming in each month, which would make them better able to adjust if a rate change results in a higher payment.

If you have a newer business that’s still ramping up, a significant increase in your monthly payment could be problematic for your budget. Choosing a fixed rate loan that has the same payment each month may be more preferable. To learn more, take a look at our quick guide to fixed interest rates.

More from the Resource Center: Fixed Interest Rate Explained

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