The Fed finally cut interest rates — but let’s not get too excited just yet

If you’re running a small business, this cut in interest rates will have little impact

(This column originally appeared in The Hill)

This week, the Federal Reserve announced a cut of 50 basis points (or half a percentage point) in the federal funds rate, which is the rate it charges its member banks. The expected effect will be that banks, with their costs lowered, will lower the interest rate they charge customers on their loans, thereby making capital less expensive and more readily available.

It is good news. But let’s not get too excited. If you’re running a small business, this cut in interest rates will have little impact.

To put things in context, the prime rate charged by most banks before the Fed rate cut has been 8.5 percent. That rate rose from 3.25 percent in May 2022, which means that the cost of borrowing almost tripled for businesses during that 15-month period. And that’s just the prime rate. Few small businesses are have access to this rate. Usually, my clients pay anywhere from 1 to 3 points above this rate, so they are paying 9.5 to 11.5 percent interest on their loans.

To do the math, before May 2022, a five-year equipment loan for $1 million would require approximately $139,159 in total interest at an average interest rate of 2 points above prime at the time, or 5.25 percent. Before the Fed’s rate cut this week, that same loan at 10.5 percent (2 points above prime) would require $289,634 in interest. By reducing the prime rate just half a percent, that annual interest cost would fall to $274,822, or $14,812 less. That’s not actually a lot — about $3,000 per year.

Of course, every little bit helps. But a $14,812 savings over five years is not likely to make a big difference to a company’s bottom line.

It’s also not going to make a big difference to the credit teams at most banks who approve these loans. According to the Kansas City Fed, new small-business lending decreased by 6.7 percent when compared to the same period in 2023, and by 6.3 percent when compared to the previous quarter. According to a Reuters report earlier this year “small business owners in the U.S. are struggling to get financing from traditional lenders as the impact of higher rates and bank failures of a year ago linger, holding back business growth for some.”

This is because one of the biggest factors for evaluating creditworthiness is the ability of a business to pay back its loans. Regardless of the collateral a business can provide, banks don’t like defaults. So as the cost of borrowing grew, the ability of many small businesses to pay back new debt they incurred became more of a risk, and therefore banks approved fewer loans.

Using my example above, the $1 million equipment loan would increase a small company’s monthly loan payment from $18,985 in 2022 to $21,493 in 2024. With a half a percent decrease in interest, that monthly loan payment would only drop by about $250 to $21,247. Unless there’s a project with an ironclad return on investment (along with collateral), I don’t think this interest rate drop is going to change any bank’s decision in any significant way.

Wall Street has been anticipating a drop in interest rates for weeks. This is why the markets didn’t significantly react when the Fed made its announcement. The decision was already built-in. The same goes for mortgage rates.

As I write this, mortgage rates are about 5.6 percent. Even if they were to drop a full half point — which I don’t expect, because these rates have also anticipated the Fed’s actions — I’m not sure it would make a significant difference to homebuyers. It still doesn’t diminish the reality that most homeowners are locked into mortgage rates that are almost half the amount of the current rate. To sell your house and take on a new mortgage twice as high — particularly when the cost of living for so many other items have increased dramatically over the last few years — doesn’t seem like something most people would do willingly.

This means we’re still going to have to wait for that long-anticipated residential real estate recovery.

I write about this because the residential real estate industry has a wide-reaching impact on businesses both big and small nationwide. Aside from the companies that directly profit from a real estate transaction (brokers, title agencies, house inspectors, attorneys, etc.), there are all the businesses that benefit from a new transaction because people renovate, landscape, repair, buy furniture, move furniture and do all sorts of other things to settle in. Those businesses will also have to wait for an uptick.

So what’s the tipping point?

To see a real impact, we need to see business rates — the prime rate particularly — fall to about 6 percent and mortgage rates fall below 5 percent, probably closer to 4 percent. It’s still higher than rates were prior to 2022, but we all know that those rates were unreasonably low for an unreasonable amount of time. The Fed would need to reduce its federal funds rate by at least a full percentage point to help accomplish this. So we’ve got a long ways to go.

But we’re heading in the right direction. And, according to news reports, there are more rate cuts to come. In the meantime, businesses shouldn’t get too excited by the Fed’s decision.