On March 16, 2022, the Federal Reserve raised its federal funds rate (referred to as the fed funds rate) for the first time since December 2018 and is expected to have additional increases before the end of the year, depending on the performance of the economy and rate of inflation. The rise in the benchmark interest rate by the Federal Reserve has a trickledown effect on your business. Some of this may be direct while some is indirect. It’s likely this isn’t the first time you have been in this situation because interest rates have been higher in the past, which is why the matter was covered in a blog several years ago. Here’s an update to that blog and how to prepare for a rising interest rate environment.
5 ways to prepare for rising interest rates:
1. Borrowing costs are higher
If your business has an outstanding line of credit, the interest rate you’ll pay is the current interest rate set by the borrower. This rate, which is likely geared to the bank’s prime rate, is effectively fixed according to the fed funds rate. As the fed funds rate increases, so does the prime rate, and thus the rate you pay on your line of credit.
It’s a fact that many small businesses use credit cards to help finance their businesses. This may be through cash advances or paying off purchases over time. As the fed funds rate rises, credit card interest rates may also increase. This is because credit card rates are tied the banks’ prime lending rate, which in turn is keyed to the fed funds rate.
What to do:
Pay down outstanding balances to the extent possible before there are even more interest rate increases. For credit cards, consider balance transfers to other cards offering zero percent for a certain period (e.g., six months or one year). But check for credit card fees and other features before selecting a new credit card.
2. Advancing credit to your customers
If you’re not paid on the spot for the goods and services you provide and instead invoice for them, in effect you’re financing your sales to customers. The longer they have to pay with no additional cost, the more you’re giving them an interest-free loan.
What to do:
Review your “lending” policy and obtain payments upfront (e.g., with down payments or advances) or at the point of sale or service. If you think you must continue to invoice for goods and services, then consider using shorter payment periods (e.g., net 10 instead of net 30 or 60 days).
3. Below market loans to owners
Business owners who need money for personal reasons may look to their company as a piggyback. However, the tax law imputed interest income to the business when the loan is below the “applicable federal rate” (APR) set monthly by the IRS; the rates vary for the term of the loan.
What to do:
Check the APR when borrowing from your company to match it and avoid imputed interest. If you want the loan to be tax free, then recognize the tax consequences to the company.
4. Higher IRS rates on tax underpayments
Each quarter the IRS sets rates that are applicable to tax underpayments by individuals (business owners) and corporations. These rates also apply to estimated tax underpayments. The rates for the second quarter of 2022 have risen over the previous quarter. More specifically, the rates for underpayments in Q2 2022 are:
- 4% for underpayments by individuals and corporations
- 6% for large corporate underpayments (amounts exceeding $100,000)
The rates that the IRS must pay to taxpayers on overpayments are also on the rise. For Q2 2022 they are:
- 5% for individuals
- 3% for corporations
- 5% for the portion of corporate overpayments exceeding $10,000
What to do:
The rise in IRS interest rates means that business owners and corporations should pay attention to tax payments and avoid underpayment penalties.
5. Higher cost of materials and supplies
Because vendors and suppliers may have higher costs resulting from increased interest rates, the price you pay will likely reflect this fact.
What to do:
Consider adjusting the prices of your goods and services to reflect the higher prices you must pay.
Most business owners today may not remember when the fed funds rate reached a high of 20% in 1979 and 1980; that was a period of extreme inflation. Today, the Fed carefully monitors the economy to help control the money supply through the fed funds fate. While there are no indications that rates will zoom from where they are now, even a small increase can cost your business significant dollars. Work with your financial adviser to minimize the impact of increases in interest rates.