What do interest rate rises mean for small businesses?

Customisable business insurance
23 March 2023
5 minute read

The influential Monetary Policy Committee of the Bank of England met this morning (23 March 2023) and raised the Bank’s base interest rate to 4.25% (a rise of 0.25 percentage points and the eleventh rate rise in the last 16 months). Beyond these figures, let’s look at what interest rates actually are, why they are rising and what rising rates mean for small businesses around the country.

What are interest rates?

In simple terms, interest rates are a measurement of the cost of borrowing money. Interest is the amount charged by a lender to a borrower – on top of the amount loaned – that needs to be paid back.

As the central bank of the UK, the Bank of England (BoE) is independent of the Westminster government and is essentially the body that acts as a custodian or steward of the UK economy. The Bank’s Monetary Policy Committee meets every few weeks and can decide to raise or lower the Bank of England interest rate in order to help stimulate the economy, control inflation and protect borrowers and savers.

The interest rates charged to individuals and businesses when they borrow money is often tied to the base rate that is set by the BoE, meaning that any decision they take has significant knock-on effects for the wider economy.

What is inflation?

The BoE's recent decisions to continue to raise interest rates are mainly with the aim of bringing down the level of inflation in the UK which is unusually high at the moment and is contributing to the cost-of-living crisis that the country is currently experiencing. A statement by the Bank explained that:

Low and stable inflation is vital for a healthy economy. An economy in which households and businesses can plan for the future with confidence and money holds its value.

Inflation is essentially a measure of how much prices have increased across the economy compared with the previous year. As of February 2023, the Consumer Price Index (CPI) measure of inflation (there are others) sat at 10.4%. This means that the average cost of household goods (or “shopping basket” as the ONS calls it) was more than 10% higher in February 2023 than in February 2022. You can read more about how the Office for National Statistics (ONS) calculates the CPI on their website.

The logic behind raising interest rates to reduce inflation assumes that higher interest rates will mean people will borrow less and save more. By saving more, consumers spend less in the real economy and this curbs price rises, reducing inflation.

What do rising rates mean for small businesses?

Reduced consumer spending

One of the most serious impacts of rising interest rates on small businesses is that as the cost of borrowing increases, consumers around the country end up paying more to service (pay back with interest) the debt they already have and new debt they take on. In short, individual consumers will spend more of their income on debt payments and will have less money to spend in what economists call the ‘real economy’, on goods and services.

The UK is undeniably a nation that runs on debt, with the sixth highest household debt to GDP ratio of the G20 nations. Britons had a personal average debt of £33,410 in March 2022, which is greater than the average adult annual income. When the cost of taking on debt and paying down existing debt increases, businesses will quickly feel the squeeze as consumers tighten their purse strings and cut back on personal spending.

The most recent Deloitte Consumer Tracker for Q4 2022 shows that consumer spending reduced on non-essential goods for a fifth successive quarter while spending on essential goods remained flat. As consumers spend less money at both small and large businesses, fewer new businesses are able to start up, more close down and those that survive are less able to grow. This can cause an economy to contract or even plunge into recession. Indeed, the Office for Budget Responsibility (OBR) predicts that the UK will narrowly avoid a technical recession in 2023 but the economy will contract by 0.2% by the end of the year.

Increased cost of business loans

While consumers spend less at their local businesses when interest rates are high, those same businesses can also face a higher cost of borrowing when they wish to take out a business loan.

In simple terms, there are two kinds of interest rates that can be charged on a business loan. Well, there’s actually more than two, but for our purposes there are two that really matter to small businesses. They are:

  • A fixed rate – this is agreed in advance and does not change over the life of the loan
  • A tracker rate – a flexible rate that moves up and down at a set level above the Bank of England base rate as that changes, meaning it can alter month-to-month over the life of the loan

When interest rates are low, businesses often opt for loans that track the BoE base rate as they can end up costing less than fixed-rate loans. However, as the Bank’s base rate rises, so does the cost of those loans that track above the rate.

Data from the Bank of England shows that the effective rate of interest charged on SME loans that track (or “float”) above the BoE base rate was 5.36% in January 2023. That is significantly higher than the effective rate of 2.08% back in March 2022.

In March 2022, the effective rate of interest on a BoE rate tracker loan (2.08%) was lower than that of a fixed-rate loan (2.2%). In this situation, it is understandable that many businesses would take out loans that track the Bank’s base rate as they seek to grow.

Fast forward 10 months and the tracker rate has increased more than two and a half times to 5.36% while a business on a fixed-rate loan taken out in March 2022 would still be paying 2.2%. It’s also worth noting that the most recent effective rate figures are from January 2022 and the Bank’s base rate has increased twice since then.

Will interest rates continue to rise?

Interest rate decisions are taken on a regular basis by the Bank of England in reaction to the current economic reality, it is impossible to know with absolute certainty what will happen to the UK’s interest rates over the next year. However, economists are predicting that the BoE base rate is likely to continue to rise into 2023 and potentially peak at 4.5% or more.

So what would that mean for small businesses? With interest rates predicted to rise further during 2023, consumers that carry debt will continue to be squeezed and it is likely that consumer spending, especially on non-essential goods, will be sluggish.

This means that businesses may have to reconsider their purchases of stock as demand falls away, or cut prices to encourage consumer spending. Businesses with loans that track the BoE base rate will also likely see the cost of their repayments go up this year as the cost of borrowing increases along with interest rates.

You may also like:

This content has been created for general information purposes and should not be taken as formal advice. Read our full disclaimer.

Share this article

We've made buying insurance simple. Get started.

Related posts