By Josh Pape, Citizens Bank of Edmond
Small business owners often ask, “Where are interest rates headed?” It’s a fair question, especially when borrowing costs can significantly affect everything from cash flow to expansion. While no one has a crystal ball or can make guarantees, understanding how the Federal Reserve (“the Fed”) influences interest rates, and how that trickles down to your local bank, can help you make more informed financial decisions.
The Fed’s Role in Setting Rates
The Federal Reserve doesn’t directly set the interest rates you see on your business loan. Instead, it sets a target range for the federal funds rate, which is essentially the interest rate banks charge each other for overnight loans. This rate serves as a benchmark for many other short-term interest rates in the economy.
When the Fed raises the federal funds rate, it becomes more expensive for banks to borrow money. In turn, banks may pass those higher costs on to consumers and businesses in the form of higher interest rates on loans and credit. Conversely, when the Fed lowers rates, borrowing becomes cheaper, which can stimulate economic activity.
How This Affects Local Bank Lending
Local banks, like the ones serving our community, may use the Fed’s rate as a guide when pricing their own loan products. If the Fed raises rates, you might see an increase in the interest rate offered on a new business line of credit or term loan. If the Fed cuts rates, borrowing may become more affordable.
But here’s where it gets a bit more nuanced: many business loans are not tied directly to the Fed’s short-term rate.
The Difference Between Short-Term and Long-Term Rates
Most small business loans have fixed interest rates for 3 to 7 years—what we call intermediate-term loans. While these rates are influenced by the Federal Reserve’s decisions, they’re also shaped by broader market forces like inflation expectations, investor behavior, and economic trends.
When the Fed lowers its short-term federal funds rate, you might expect all interest rates to fall. But that’s not always the case for longer-term loans. If investors believe a rate cut will lead to stronger growth or higher inflation, they may demand higher returns on long-term investments like bonds.
Another factor is global demand for U.S. Treasury bonds. If investors pull back due to concerns about government debt or fiscal policy, bond prices fall and yields rise—raising long-term borrowing costs. Since many loan rates are tied to these yields, a 5-year loan rate could actually increase even as the Fed is cutting rates.
Banks often use bond yields, especially U.S. Treasury yields, as a baseline when pricing loans, because those yields represent a virtually risk-free return. Lending to a business can carry more risk, including credit, liquidity, and operational risks.
To account for that, banks may add a risk premium on top of the bond yield. So, if a 5-year Treasury yields 5%, a bank might price a 5-year business loan at 7% or more (for example), depending on your credit profile and market conditions.
In short, your bank isn’t ignoring the Fed, it’s responding to a different set of market signals.
What This Means for Your Business
Here are a few key takeaways for small business owners:
- Stay Informed, But Don’t Overreact: Fed decisions are important, but they’re just one piece of the puzzle. Don’t assume that a Fed rate cut automatically means cheaper loans or that a hike means you should rush to borrow.
- Understand Your Loan Structure: Ask your banker whether your loan is tied to a short-term benchmark (like the “SOFR”) or a longer-term rate. This will help you anticipate how your payments or rate might change over time.
- Plan for Rate Fluctuations: If you’re considering a loan, think about how rate changes could affect your monthly payments in the future, not just the cost of credit today.
- Build a Relationship with Your Banker: A strong relationship with your local bank can give you access to better advice and more flexible financing options. We’re here to help you navigate these decisions, not just originate a loan.
Looking Ahead
As of now, market watchers are closely monitoring inflation data, employment trends, and global economic signals to predict the Fed’s next move. Whether rates go up, down, or stay the same, the key for small businesses is to stay agile and informed. At the end of the day, interest rates are just one factor in your business’s financial health. But understanding how they work and how they’re influenced can give you a strategic advantage
About Josh Pape
Josh is the Chief Lending Officer at Citizens Bank of Edmond. Josh is a seasoned community banker who has served in various executive roles with several years of experience in commercial lending, mortgage lending, retail banking, treasury management and bank operations. As Chief Lending Officer, he leads Citizens’ commercial and mortgage lending teams. Josh was selected in 2022 by the Independent Community Bankers of America (ICBA) as one of the country’s Top 40 Under 40: Emerging Community Bank Leaders. He is a U.S. Air Force Veteran and holds an undergraduate degree in Business Management from Western Governors University, where he became the first male college graduate in his family. He also serves the broader community banking industry where he is the Chairman-Elect of the Community Bankers Association of Oklahoma’s (CBAO), and is a member of the ICBA Safety & Soundness Committee. Josh and his wife, Jennifer, are proud parents of two children and active residents of Edmond, Oklahoma.