For U.S. small businesses, interest rates are a key issue next year

MeterOver the next year, most small businesses in the U.S. will continue to grapple with a slowing economy, inflation, supply chain challenges and labor shortages. But our biggest question will be interest rates. Interest rates rise sharply in 2022 – by 2023 these rates will be affected.

As recently as March, the federal funds rate (the funding rate the Fed charges banks) was 0.25%. It is now 4.33%. During the same period, the average prime rate for most banks rose from 3.25% in March to 7% today due to higher operating costs.

This is the prime rate, the best rate the bank offers to its best, biggest blue-chip customers. When we get a loan from a bank, you and I don’t get prime rates. A typical small business pays two to four percent more than the main fee. That means that as I write this, my clients are paying 9% to 11% interest on their loans, more than double what they were earlier this year. And all of this excludes the Fed’s plans to raise rates by another 50 basis points soon and its threat to raise rates further to keep inflation in check.

this is a big problem.

If a small business has a $1,000,000 loan, the interest expense will increase from $70,000 to $110,000 next year. An extra $40,000 could cover an hourly worker, or more employee benefits, or repairs or more materials or many other things. But instead, it goes to the banks so they can meet their obligations to the Fed (and profit from it), and the Fed doesn’t buy anything at all.

These are the costs of traditional bank loans, which many small businesses simply cannot get because of lack of collateral, history and other risk factors. The cost of alternative financing — online loans, merchant advances, credit card borrowing — is much higher.

This will have a major impact. When the cost of something more than doubles, it becomes too expensive for some people to buy. This is what will happen in 2023.

Startups will not be able to afford the financing needed to launch, and early-stage companies will not be able to raise the financing they need to grow. We’ve seen this in the tech industry, where venture capitalists and other investors pulled back on unprofitable early-stage companies, leading to tens of thousands of layoffs and hundreds of closures.

My clients are primarily business-to-business, employer-owned businesses that manufacture, distribute and service. Some of those customers had fixed-rate mortgages and equipment loans that were taken out when interest rates were much lower. But few would be interested in new loans to finance new acquisitions, because interest costs weigh heavily on the return on investment they get from those investments.

Even more worrisome is the cost of working capital loans extended to small companies, which are almost always variable and vulnerable to fluctuations in interest rates. Working capital loans are used to finance inventory purchases, shipments until customers pay, labor costs, and other operating expenses. If these costs continue to rise, fewer and fewer businesses will be able to afford these activities, which will have a significant impact on their profitability, not to mention their sustainability.

Mergers and acquisitions will decrease in 2023 as companies find it harder to raise capital to buy other businesses, meaning business owners looking to sell and retire will have to wait or accept lower payouts. Funding overall will tighten as notoriously risk-averse banks further shy away from risking smaller companies.

The impact of increased interest costs will significantly increase our expenses. But what about income?

Rising mortgage rates have shrunk much of the residential and commercial real estate industries, depriving sales and profits of countless businesses that depend on the industry for their livelihoods. Larger projects requiring financing will be curtailed, delayed or canceled. Cars are now more expensive to buy due to higher loan and lease costs, meaning businesses that support the auto industry are suffering.

In addition to all the financial services industries that make money through interest income and capital gains, there are countless small businesses in manufacturing that provide parts, labor, and services to customers, as well as make equipment and machines, but they will decrease as demand for equipment declines. Build them because their customers will defer paying higher loan rates.

good news? This won’t last forever. Nothing at all. The Fed is raising interest rates for the right reasons, which is to control the inflationary environment we’re in right now. Some businesses shrug off higher interest rates as long as they can make acceptable profits by raising prices or reducing overhead. Anyone who’s run a business for over 20 years — like me — knows that none of this has been seen before. I believe things are moving in the right direction now.

But there will be pain until we get back to reasonable inflation and interest rates, because it will take time — at least a year, possibly longer. That means if you’re running a business in 2023, it’s all about interest rates.

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