Lower Rates are Good for Business
The Federal Reserve recently began lowering interest rates for the first time in over four years. Small businesses are particularly likely to benefit from the rate cut because many are dependent on bank financing and have floating rate loans. Indeed, 80 percent of Small Business Administration (SBA) 7a loans have variable interest rates, and as many as 200,000 small businesses will see lower loan payments as soon as October 1st. Moreover, the Small Business Administration announced new rules to make it easier for the thousands of small businesses with fixed rate loans to take advantage of falling rates through refinancing. Given that many small businesses operate on thin profit margins, this blog highlights how the recent tick down in interest rates (see Figure 1) and Administration actions will help thousands of small businesses prosper.
Entrepreneurship is linked to economic mobility and wealth accumulation. Also, small businesses, commonly defined as those employing fewer than 500 employees, employ a substantial share of the U.S. workforce (46 percent in 2021) and account for 2 out of every 3 jobs added in the past 25 years. Simply put, promoting small business is integral to promoting economic growth in the United States.
While a fortunate few are able to start businesses using personal wealth, bequests, or lottery winnings, access to credit markets is critical to entrepreneurship. Increased access to bank financing has been shown to increase entry into entrepreneurship, and home equity is an especially important source of credit for new and small business entrepreneurs. Moreover, in a credit constrained environment, small firms that are the most reliant on credit have much weaker employment growth than those that are less reliant on credit. This all underscores the importance of facilitating low borrowing costs for business formation, business growth, and job growth.
The interest rate at which an entrepreneur can access credit can make or break a business. To see this, Figure 2 plots the annual payment on a 12-year fixed-rate loan of $480,000. This is the SBA 7a average loan term and amount for the 2023 fiscal year.[1] Each percentage point decrease in the interest rate charged would save about $3,200 in annual loan payments. For many businesses even a half-point reduction would significantly increase profit margins (revenues less operating costs and interest payments). Margins can be below 1 percent for small businesses in sectors like childcare, and many small businesses struggle to stay afloat in the first few years. As such, the reduced loan service costs due to falling interest rates could be the difference between success and failure for thousands of small businesses.
To allow more businesses to take advantage of the lower interest rates, the Administration’s new rules will lower loan costs for small business owners by expanding access to its 504 refinancing program. A 504 refinancing loan allows a small business to purchase new business assets or to lower payments on existing loans initially taken out to purchase new assets. The new changes will enable lenders to increase 504 loan refinancing capacity, make it easier to spend more 504 refinancing funds on a wider range of items, and remove requirements that limit borrower eligibility based on expected loan savings. In doing so, the new rules will remove a key barrier for the growth and establishment of small business.
During the past three and a half years, 19 million new business applications (of all sizes) have been filed – a pace that is higher than under any four-year Presidential term since these data were recorded, and the year-over-year establishment growth (4.3 percent) has been faster than in any single year in the last quarter-century (Figures 3a and 3b). Lower rates will enhance these gains, and the new Administration rules that make it easier for business to refinance and take advantage of these lower rates will provide an additional boost to small businesses. Moreover, because veterans, women, and ethnic minorities are more likely to rely on rate sensitive sources of credit, these actions may facilitate greater diversity in business ownership.
[1] Note that most SBA loans are variable rate. We use a fixed-rate example for illustrative purposes.
