How Today's Federal Interest Rate Impacts Your Small Business

You don’t need an economics degree to understand the basics of federal interest rates and how they can affect your small business’s bottom line. Here are a few key concepts that you should know.

Federal Funds Rate

Banks nationwide maintain their balances at the Federal Reserve (“the Fed,” sometimes called “the banker’s bank”). To keep their balance sheets straight and comply with regulations, they often lend this money to one another on a short-term basis. When they do, they use the federal funds rate.

The media often imply that the Fed mandates this interest rate, changing it to achieve desired economic results. In reality, the Fed sets a desired “target” rate, and the banks themselves determine the final “effective” rate. (Borrowing and lending banks negotiate this fair-market rate among themselves, without involving the Fed.)

Prime Rate

The prime rate is the interest rate that banks charge their most creditworthy customers (usually large, stable corporations). The banks arrive at this figure by adding a percentage to the federal funds rate. For example: in recent years, the federal funds target rate has remained between 0% and 0.25%, and banks have been adding 3% to get their prime rate (3% to 3.25%).

The Wall Street Journal is a great source for information about the prime rate. It polls 10 of the nation’s largest banks; when at least seven of them change their prime rate, the WSJ updates its published rate to reflect this new value.

Your Interest Rate

The prime rate is meaningful for small businesses and consumers because it is used as a benchmark for rates on many consumer loan products, such as credit cards or student loans. When shopping around for a business loan or line of credit, you may find that banks determine your interest rate (in part) by a) taking the prime rate, and b) adding a margin of a few more percentage points. So if the prime rate is 3.25%, you may be quoted a rate more like 5.25% or 6.25%.

You might think of interest rates like layers of an onion. Your interest rate is often tied to the prime rate. The prime rate, in turn, is pegged to the federal funds rate. When the Fed rate and/or prime rate starts to move, be prepared for possible changes to your interest rate, which can impact your small business.

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