Interest rate increase: What would it mean for UK SMEs?

As if the past eighteen months haven’t been challenging enough for small business owners, alongside ongoing staff and supply shortages, SMEs might now have to add rising interest rates to their list of plates to spin in 2021.

Taking part in an online discussion last Sunday with the G30 group of central banks, the governor of the Bank of England, Andrew Bailey said that rising energy prices, and the impact of coronavirus, had contributed to the recent jump in inflation which might necessitate a rate rise either later this year or early 2022.

But, as we near Halloween, is this announcement a Trick or a Treat for small business?

We spoke to some small business owners as well as financial experts to find out more about what the impact of a potential rise in interest rates would be, and how UK SMEs can prepare.

Why are interest rates set to rise?

The biggest contributor to a rise in interest rates is inflation. Inflation, simply put, is a price level rise in the economy.

Inflation has been rising steadily in the UK, triggered by increased government spending as a response to coronavirus. It matters because it has a direct impact on the cost of products and services. In fact, the latest ONS figures from September 2021 show that prices rose by an average of 3.1% over the past 12 months.

The Bank of England (BoE) has already warned that inflation is due to reach higher than 4% in 2022 – more than double the BoE’s target. During his discussion with the group of G30 banks, governor of the BoE Andrew Bailey told attendees that the monetary policy committee (the group of policymakers responsible for guiding interest rates) “will have to act and must do so if we see a risk.”

Most analysts agree this refers to increasing interest rates. At the moment, it’s unclear what rates could rise to, although The Sunday Times’ City Editor, Jill Treanor reported they could climb to 1% by the end of 2022.

How would higher interest rates affect the economy?

In general, higher interest rates increase the cost of borrowing. As the value of loans decrease, lenders need higher interest rates as the money they are paid back shrinks in value.

That means if interest rates are higher, businesses will be restricted from growth strategies like taking out loans, investing in new equipment, or hiring more workers. Higher interest rates also reduce disposable income as interest on loan repayments, such as mortgages, increases. This would limit consumer spending, which could hit small business revenue.

Of course, the impact is not all negative, otherwise higher interest rates wouldn’t be introduced. An increase also tends to reduce pressures caused by high inflation, and means people are less likely to engage in risky investments and borrowing. This means that the economy is more closely moderated which is good for stabilisation, but bad for growth and employment.

Economists are divided on whether interest rates should be increased or whether this will slow down the financial recovery from COVID-19, particularly given the current materials and staff shortages facing many UK businesses.

What does this mean for SMEs?

Because interest rates are essentially a tax on borrowing, they disproportionately affect small businesses over medium-sized ones, as small businesses in their early stages of growth rely more heavily on funding.

The UK has had record-low interest rates since the 2008 financial crisis, as banks attempted to stimulate the economy back to good health by slashing rates to 0.75%. Following the disruption of the coronavirus pandemic, they were lowered to their current base rate level of 0.1%.

Increasing rates now means that UK small businesses with company credit cards and existing loans will be forced to spend more on interest payments, reducing cash flow by giving you less disposable income and bigger overheads.

Who will be most affected?

Interest rates make borrowing very expensive. That means navigating higher rates will be particularly difficult for companies which have already struggled due to coronavirus and have accessed financial loans for support. It will also be harder for startups to access finance.

Finance companies, such as mortgage brokers, are also likely to see a reduction in business as fewer people choose to borrow.

How are UK small businesses reacting?

Some small business owners we spoke to were adamant that increasing interest rates was a bad idea for SMEs, feeling that consumer spending needs to be encouraged not restricted, and expressing worries about a rise in cost of living for self-employed workers.

However, some respondents felt that raising interest rates was a logical decision, and would be beneficial in the long term.

Is a rise in interest rates definite?

As indicated by the stockpiles of toilet paper in some supermarket trolleys last year, we’ve seen how quickly today’s headlines can cause chaos. But if you’re concerned about the impact of rising interest rates then please don’t start panic-borrowing just yet.

So far, the BoE has been cautious about dealing in absolutes. While a rise in interest rates looks likely, the current forecast for the UK economy is cloudy – what with the plethora of challenges today’s small businesses are facing, you should be wary of listening to anyone who sounds certain of what will happen.

How can you prepare for the potential increase?

If interest rates are increased, it will be a gradual process. It’s extremely unlikely that they’ll suddenly skyrocket overnight, which means there is plenty of time for you to plan for the future and how they might affect your business.

Revisit your business plan

First and foremost, revisit your business objectives to make sure they are flexible enough to withstand the changing environment. If you have growth plans in place, make sure you have the capital available to enact them as higher interest rates might affect your profitability – which can make it harder to secure funding. You can discuss with a third-party accountant or financial expert to evaluate your available capital and whether you will be able to sustain your growth momentum.

This is also a good time to look at the type and levels of your debt. For example, it might make sense to opt for a personal, short-term loan to pay off a credit card with substantial interest.

But make sure the numbers add up before you borrow. In 2020, the average interest rate on a credit card was 25.4%, while the average rate on a personal loan was 9.41%, which means in this case you’ll likely be able to pay off your balance faster and with less interest.

Limit spending where you can

In order to preserve cash flow, you should start to think about the areas in your business costs where you could potentially save money by spending less.

Variable costs – examples include credit card fees and production supplies – are likely to get more expensive so you might want to look at switching to a cheaper business card plan or finding a new supplier.

This is more difficult for fixed overheads, such as rent, mortgage, or employee salaries, which will increase by default if interest rates rise. Reducing these is possible, however it might require some big actions, like relocating to a cheaper office location.

Keep an eye on your supply chain

Remember, while your company finances should be your first priority, you also need to consider the health of your customers and suppliers. Your partners might be hit with more expenses, particularly if they are involved in manufacturing or distribution, as inflation tends to heavily impact importing and exporting.

Fixed contracts are a good way to ensure that your payments stay the same across the supply chain. If this isn’t possible, it might be a good idea for you to increase your prices in-line with the added cost.

However, this could discourage new customers from purchasing your service or product, which means this decision shouldn’t be taken lightly. We’d recommend consulting with a third-party accountant or financial expert before taking such measures so you can understand the full impact this would have on your business.

Conclusion

The notion of rising interest rates, understandably, is never going to excite small business owners.

However, particularly given their current base rate of 0.1%, it’s unlikely that interest rates will go anywhere but up. While the timing of these rumours seems chaotic in the face of other business challenges, rate changes are a fact of life for SMEs to navigate.

UK small businesses should look to financial experts and third-party accountants now to prepare for the change, should it be introduced – as the earlier you plan your route, the more likely that the path will run smoothly.