The Effect of Interest Rates on Business

When the economy is strong, everyone dreams of low interest rates, because this makes it less
expensive to borrow money. The Federal Reserve sets low interest-rate targets in its effort to spur
the economy out of recession. Lower rates encourage businesses and consumers to borrow and buy
things. Loans put money into circulation and raise the money supply, which supports an economic
recovery -- to a point. Low interest rates can also be a damper on the economy and your business.

No matter how well your business functions, it depends on the economic environment to be healthy
and prosperous. Economic influences such as interest rates can help your company or hold it back.
Once you understand the context for running your business, you can adjust to interest rate moves to
protect yourself from negative effects and take advantage of positive ones. Interest rates can be a
signal to either expand your business or pull it back.

Lower interest rates encourage additional investment spending, which gives the
economy a boost in times of slow economic growth.

Low Interest Rates and the Economy

When people can't earn attractive interest income on their money in savings accounts

and certificates of deposit, they either use their money to pay down debt or invest in

goods, services or assets like houses and stocks. This means banks lose deposits. Low

interest rates also affect insurance companies that rely on a certain interest-based

return on the money they receive in premiums to support their coverage liabilities, so

your insurance premiums may rise. Low interest rates also negatively affect people who

live off the interest income from their savings, so they cut back their spending. When a

large group of people, such as baby boomer retirees, reduce their spending, overall

economic activity slows. That can act to cut your sales.

Borrowing Money Becomes Difficult

A normal economic contraction is the result of the Fed raising interest rates and

removing money from the monetary system, so when it comes spurring growth to boost

the economy out of a recession, the Fed might aim to lower interest rates a few points

to encourage small business and consumer borrowing. Banks have lots of money in

their deposit accounts, attracted by high interest rates, so they are eager to lend to

you. However, when interest rates are abnormally low, banks don't have a high deposit

base and the income from loans doesn't encourage taking risks, so they only loan to
borrowers with the highest credit ratings and substantial assets to collateralize those

loans. That is why it is difficult for you to finance your small business operations and you

might even have to lay off some of your employees to reduce your expenses as your

business slows because your customers can't borrow to buy from you.

Liquidity Trap and Deflation

A liquidity trap happens when interest rates are so low that they don't serve the normal

function of spurring the economy to growth. Instead, they reduce the flow of money to

the Main Street economy because it goes into investments in assets that don't produce

employment, such as the stock market and paying down loans. This means money

doesn't flow through the economic system. When that happens, unemployment rises as

companies lay off expensive workers and hire contractors and temporary or part-time

workers at lower prices. When wages decline, people can't pay for things and prices on

goods and services are forced down, leading to more unemployment and lower wages.

This is the danger of deflation, which is difficult to stop as the economy spirals down.

Potential for Inflation Later

Normally, low interest rates encourage loans, and loans add new money to the money

supply. After the credit crisis of 2008, for example, the Fed lowered rates and injected

money into the system to try to spur economic activity. This created a large money

supply and a liquidity trap. In a normal economy, too much money in the system results

in inflation because it chases a fixed amount of goods and services, so prices rise. The

risk of recovery from a liquidity trap is inflation if the Fed doesn't remove enough

money from the system as money comes out of assets and enters circulation in the

business and consumer economy.

The Cost of Borrowing

When interest rates rise, banks charge more for business loans. This means you'll need to use more

of your earnings to pay interest on your loans, which decreases profits. You might decide not to start

new projects or expansions during periods of high interest rates, which hampers the growth of the

company.
When interest remains low, businesses can borrow more readily. Low-interest loans can fund

business growth and increase profitability because businesses can earn enough off of new ventures

to pay for the loan interest and have money left over for profits.

Customers' Ability to Pay

Customers have to pay interest on their personal loans, home loans and car loans. The higher the

interest, the less money in customers' pockets. This can reduce their ability to buy products and

services, so businesses may suffer from a decrease in sales.

When interest rates remain low, customers have more cash after they pay their loan payments, and

they can spend this cash with businesses. This principle applies whether your customers are the

public or other businesses. Both have to pay interest on their loans, so the lower the interest, the

more they can buy.

Boosting Business Investment

Businesses can invest their excess cash in interest-bearing accounts to make more money. During

periods of high interest rates, businesses earn more from these investments.

When rates are low, businesses may be more likely to use their cash for new equipment and plant

improvements. While this can be good for equipment sellers and construction firms, banks lose out.

Banks make their money from providing loans. When they don't get business investments to boost

their assets, they can't make as much money because they have less to loan out.

Too Low, Too Long

The interest rates banks charge are their income after expenses. When banks don't see an

opportunity to make a reasonably-high interest rate on their money, they become less likely to take

risks on loans. Potentially, that might mean you'll have trouble borrowing money for start-up and

expansion expenses. Business can slow down to a crawl because there's no way to fund innovation.

In addition, short-term loans to cover cash-flow problems can be hard to come by. This could cause

businesses to be unable to deliver goods and services to their customers because they don't have

the cash to continue operating.

WHY WE CAN’T HAVE LOW RATES
FOREVER
If the Fed leaves rates too low for too long, there are several major risks
including the following:

(1) Too Much Debt: Consumers, corporations and governments will borrow

too much money that they often cannot pay back, particularly during
economic downturns, causing or exacerbating recessions.
(2) Asset Bubbles: Unusually low rates effectively increase the money
supply, partially because of the excess lending and borrowing, and this
creates asset bubbles that often pop with disastrous consequences.
(3) Inflation: The effective increase in the money supply often fosters
inflation like we saw in the 1970s.

We saw the “too much debt” and “asset bubble” issues play out in near
perfect form prior to the 2008 housing meltdown, when consumers borrowed
far more than they could pay back and housing overall was the asset bubble
that popped.

While low rates appear to help those of us in the mortgage and real estate
industries, that is clearly not always the case. Sometimes rate increases are
the best thing for all of us.
When interest rates are low, mortgage payments decline, businesses can afford to expand because
the cost of their capital is low, consumers are encouraged to buy on credit and investors having a
hard time finding high-yield investments tend to invest in startup businesses.

Cost of Credit

Low interest rates encourage consumer spending. Consumers take advantage of low interest rates

by buying houses, cars and other big-ticket items because the interest payments they will have to

make on loans to buy such items will be low and their total payments more affordable. When the

housing market is active, employment in the construction, manufacturing and services sectors rises,

because contractors hire workers, buy building materials and appliances; landscapers and nurseries

experience booming business; and new homeowners spend money on things like furniture and

interior decorators. When the automobile market is active, dealerships hire more salespeople and

manufacturers hire more workers and buy more steel, plastics, glass and parts.
Business Expansion

Home construction, auto sales and purchases of consumer durables bring increased business to a

multitude of lower-level suppliers, who manufacture and distribute the materials used in these

products. As business increases for a company, that company generally needs to hire workers, buy

supplies, update machinery and rent larger facilities. All this can be done at a lower cost during

periods of low interest rates. That is why companies take advantage of low interest rates to expand

their operations. When a company expands, its advertising and marketing activities also increase.

This translates into more jobs for sales reps, customer service reps and advertising companies.

Expanded business also increases the need for trucking, rail shipment and marine shipping, and it

produces export and import activity.

Alternative Investments

When low interest rates have the effect of increasing business activity, corporate earnings rise and

the stock market rallies. A stock market rally produces investment profits that increase wealth in

personal investment and retirement accounts, and this increases the money supply in the country

and encourages consumer spending. Low interest rates also lower the interest income on bonds,

encouraging many investors to seek alternative investments that can produce a higher return. In

addition to investing in common stock, many investors are drawn to investments in startup

companies because of the potential they present for income and capital gains.

 When interest rates fall, the opposite happens. People and companies
borrow more, save less, and boost economic growth. But as good as this
sounds, low interest rates can create inflation. Too much money chases
too few goods.
 The Federal Reserve manages inflation and recession by controlling
interest rates. So pay attention to the Fed's announcements on falling or
rising interest rates. You can reduce your risks when making financial
decisions such as taking out a loan, choosing credit cards, and investing in
stocks or bonds.
 Interest rates affect your cost of borrowing money. Always compare
interest and APR when considering a loan product.
How could falling interest rates affect your investments?

Savings rates tend to fall in response to a rate cut, unless you have your money
in a fixed rate account. The worry is that with rates so low savers might stop
saving altogether.

And anyone choosing to use a pension pot to purchase a standard annuity – an

income for life – when interest rates drop will usually get less income for their
money.

But low interest rates make it cheaper to borrow money.

Mortgages should get cheaper. Most borrowers with tracker mortgages should
see their bills fall soon as their repayments drop in line with the base rate cut.
– though a few may find they have a deal where the reduction is less than the
base rate cut or a floor is applied to how low their loan rate can go.
Homeowners paying a lender’s standard variable rate may see their repayments
drop – but it is up to individual lenders as to when or even whether they will
pass on the cut. Those with fixed rate home loans will continue to pay the
same until their deal ends. However, borrowers might see the cost of new fixed
rate mortgages falling to reflect the cheaper cost of borrowing.

Low borrowing rates should in theory encourage both consumers and

corporations to borrow, spend and invest more. This in turn can lead to
stronger economic growth, higher share prices and rising inflation.

In such circumstances, this can help drive up share prices, especially those of
companies that rely heavily on consumption.

The pound and stock markets are also affected by rate changes. The first
emergency rate cut to 0.25% sparked an initial fall in the pound against the
dollar, for example, while the stock market rose.

Though the falling pound means you pay more for your holiday money, it can be
a boon for UK firms that earn much of their money in foreign currencies. This is
because a drop in the value of the pound makes UK exports more competitive.
But equally, imports may become more expensive, therefore contributing to a
higher cost of living.

A low or falling interest rate environment can help to boost bond prices too, as
bonds have an inverse relationship to interest rates. In other words, when
interest rates rise bond prices tend to fall because the fixed rate of interest
they pay becomes less attractive to investors but when the cost of borrowing
eases, prices typically rise because the fixed rate of interest they pay becomes
more attractive to investors.

An interest rate cut is bad news for savers, “but it is

something of an unexpected gift for borrowers and investors,”
says Mark Hamrick, Bankrate.com senior economic analyst.

Financial Products

The problem for commercial banks is that government bond and

mortgage interest rates keep going lower, but it isn’t as easy to cut
deposit rates—the rate at which banks themselves borrow from
customers—at the same pace. After all, it’s tough to convince people to
keep deposits in an account that returns less than they put in (even
though this already happens, invisibly, through inflation).

Depositors may try to switch to cash, or buy some other sort of asset
(bonds, stocks, gold) to avoid taking a hit in their savings accounts,
which makes banks reluctant to cut deposit rates below zero. That’s
why the net interest margin, as the gap between long-term loan rates
and short-term funding rates is known, keeps getting leaner.