Yesterday, the Bank of Canada announced that is overnight lending rate would stay put at 1%.
On the surface this would appear to be good news, but for whom?
If you’re a consumer with a variable interest rate mortgage, this is very good news as your mortgage rate is not likely going up.
If you’re a business owner that can qualify for low risk credit, your cost of going business isn’t going to increase due to more financing costs.
But for most sources of consumer or business financing, a change in the rate doesn’t really make a whole lot of difference which is where the perception issue comes in.
Because individuals read and hear about the low levels of the prime lending rate, they automatically believe in many cases that this represents the average cost of money or somehow reflects the cost of capital that would relate to them.
The prime lending rate posted by banks is basically a low risk lending rate where there is very little chance of the bank losing their money on a loan in the event of default.
If this is not the case, then the cost of money is appreciably higher to compensate for the relative risk.
So on the surface, a business owner may somehow feel entitled to a lower cost of financing than he or she can find on the market. But in reality, interest rate perception should be more about your cost of doing business and how to reduce it over time.
Let’s take credit cards.
While there are a wide range of credit cards on the market, most carry a pretty healthy, and some would even consider obscene interest rate. And while we all grumble about this, its pretty much accepted as the way things are and unless we are carrying balances month to month, it doesn’t really matter.
But from a business owner’s point of view, certain credit cards charge the vendor a fee for processing their customer transactions, which is a big part of the their profit stream. And this cost isn’t cheap. It can range from 1.5% to upwards of 3.0% of the value of the transaction.
If customers expect to use certain credit cards that charge a vendor fee, then its a cost of doing business which either needs to be built into the price, or paid from the existing margin. If you can’t do that, then you can’t provide the option to the customer.
Similar with asset based financing, most notably factoring, or invoice discounting, where the business can be paying anywhere from 1% to 3% a month on invoices they finance in order to generate more working capital to purchase inventory, pay supplier bills and so on.
If the cost of financing can’t be reduced by some combination of early payments to suppliers, purchase discounts, price increases, then its a permanent cost of doing business that either can or can’t be covered by your margins.
Over time, as your business builds financial strength, cheaper forms of money will likely come available, at which time your cost of doing business will go down.
The key for any business owner is to understand the relative cost of financing for his or her business and then decide whether or not they can compete in the market place with that cost and grow to a size and level of efficiency that can qualify for cheaper credit.
The cost of money is a true barrier to entry as well as business killer if you don’t understand it properly and manage it well.
If the prime rate is relevant to your business, then pay attention to it. If its not, don’t waste valuable time chasing something that you’re not going to be able to get a hold of in the near term.
The prime rate being low is good for the economy as a whole which is likely going to be at least an indirect benefit to most businesses. But that doesn’t mean it going to reflect your personal cost of capital.