By Karen E. Klein Short-term interest rates are rising, and rising fast. The Federal Reserve Board has hiked them six times since June, 2004, hoping to cool down a growing economy and avert inflation. Many small-business owners are aware of pronouncements by Fed Chairman Alan Greenspan, but they may not fully understand how changes in short-term rates affect their companies. And they should, says Tom Nist, senior vice-president for business banking at Pittsburgh-based PNC Bank.
Nist calls short-term borrowing "the blood that runs through a small business on a day-to-day basis." Smart Answers columnist Karen E. Klein recently spoke with Nist about how entrepreneurs can best navigate a rising rate environment. Edited excerpts of their conversation follow:
Q: Can you put the rise in short-term interest rates in the context of what has been happening in the economy over the last few years?
A: During the early 2000s, Alan Greenspan lowered short-term rates repeatedly to stimulate the economy. Cutting interest rates allows for more affordable borrowing, which creates fuel that gets the economy going again. Apparently, what he did worked, though the economy is recovering faster than jobs are.
Last year, with signs that the economy was getting stronger, we began to get intermittent hints about inflation, because if short-term money is too cheap, that might overstimulate the economy and introduce the threat of inflation. That's why Greenspan and the Fed's economic managers have increased the short-term rates six times since last June.
Q: What's next?
A: We're hearing and predicting there will be a few more increases in the near term.
Q: So how does this continuing trend affect small businesses?
A: Well, because rates have been so low for so long, the notion of the cost or opportunity presented by interest rates may have become something of an afterthought for business owners over the last five years. For instance, investment rates on something like a money-market account might have been as low as 0.5% until recently. So if you're a business that has a pile of extra cash you keep on hand, it didn't really matter where you parked it. The yield was so low that it became unimportant.
Now, that rate of return is starting to get significant again, and the opportunities for short-term liquidity are getting more attractive. Those rates are not where they were when companies were investing in the '90s, but they are up as much as fourfold. Today, if you shop around for it, you might get a money-market account that pays 1.5% to 2%.
Q: So business owners may want to revisit the decisions they have made about investing their reserve accounts?
A: Yes. Five years ago, a lot of companies had a checking account and a money-market account. Back then, you could easily find a 5% or 6% return on the short-term market. But since rates dropped, there has been a migration toward companies putting all their cash in a checking account, where they earn no interest because a quarter-percentage point or half-percentage point wasn't worth it. Today, it might be worth it to put some of that surplus cash back into an account where it can earn a return for you.
Q: Savings aside, how has the current environment affected other areas, like securing capital?
A: Many businesses use short-term borrowing to shore up their cash flow or to cover expenses as they gear up for a high-sales season. They may have a line of credit, for instance. Those short-term loans have been very cheap for a long time, and lots of institutions have been out there promoting attractive rates.
But many short-term lines of credit are indexed to an industry benchmark, so as the rates rise, the interest rate on that line of credit is also going to go up. Companies may not realize that they are paying more for that money. So they should keep an eye on their loan payments.
Q: Should companies rethink their short-term borrowing?
A: Not necessarily. Short-term floating rates can still be attractive, since those types of loans are primarily used for business growth. If the economy is driving more business growth to a small business, it can still reasonably opt for this slightly higher cost of financing, for the leverage and flexibility it provides. And short-term credit is so much more available to small businesses, especially those that are just starting out.
So keep going if it's best for business, but also be aware that it might cost more than it used to. If you have a variable-rate home-equity line of credit, for instance, watch your bank statements. Some institutions will reprice the entire outstanding balance as interest rates go up. Others will only reprice the new draw.
Business owners should also be aware that certain lenders will lock in interest rates for their long-time users of lines of credit. Companies get comfortable with a line of credit and use it to finance equipment purchases or other long-term borrowing. So if you started with a short-term line of credit, but you've been in business for five years now, are established, and have cash flow, you might want to think about converting that permanent inventory financing to something more like a term loan and lock in a low rate.
Although the cost of short-term financing is rising, long-term rates have not moved at the same pace, though historically long-term loans tend to be a bit more expensive. This isn't for a company that just borrows once a year to finance seasonal inventory, by the way - only for companies that borrow every month and plan to continue for the foreseeable future.
Q: How much importance should small-business owners place on rising rates?
A: Alarms are not going off yet, but even the absence of an alarm is probably a risk for a small company with tight cash flow. The bottom line is that you have to think of cash as a raw material, and the cost of that raw material has gone up fourfold in the last six months. If that happened anywhere else in your business, there would be a battle cry to pay attention and do something about it. Klein is a Los Angeles-based writer who covers entrepreneurship and small-business issues