Business Loan Interest Rates: The Basic Guide
Starting a new business requires passion, drive and an idea that can be monetized. It also takes money to make money, so starting–and running–a business requires capital. For owners who do not want to rely on their own assets, or those of friends and family, there are many financing options to evaluate.
The National Small Business Association notes that more than two-thirds of small business owners used some method of financing in 2017, with a combined 38% getting a loan from a bank, credit union, the Small Business Administration or an online lender. All lending options come with their own pros, cons, and considerations, a significant one of which is the interest rate.
Several factors – including the age and revenue history of your business – are critical in determining what type of business loan and therefore, what interest rate you qualify for. Whether you are just beginning to investigate financing options for your brand-new business or have years of experience and just want to shop around for a new lender, make sure you’re aware of the nuances of today’s interest-rate environment. This figure will is the primary determinant of what you’ll pay to your lender over the life of your loan on top of the sum you’re borrowing.
Compare and contrast: Business loan need-to-knows
Fixed vs. variable rates
Fixed rates and variable rates are just as they sound; the former rate is locked in for the life of the loan, while a variable rate is subject to increase or decrease along with the ebbs and flows of the interest-rate environment. A fixed rate can make it easier to budget for payments because the payment won’t change. While less predictable and subject to change as frequently as every month, a variable rate may also be lower at the outset of the loan. For this reason, lenders seeking a short-term loan may prefer a variable option.
Most variable rates are tied to either the London Interbank Offered Rate (LIBOR) or the prime rate. Lending institutions consult these rates as a benchmark and then use other variables to determine how much of a surcharge to add if any.
The prime rate has varied from in the past 20 years from a low of 9.50 percent to a low of 3.25 to the current rate of 5%. While this is near a 10-year high, it remains relatively low from a historical perspective.
Simple interest vs. compound interest
Even if two loans have the same general terms such as amount borrowed, interest rate and repayment period, the difference in how interest is calculated, simple or compound, can make a difference in overall interest paid.
A loan with a simple business loan interest rate charges interest only on the total amount initially borrowed:
Simple interest = Principal (P) x Interest Rate (R) x Term in years (T)
For instance, a borrower who takes out a $25,000 loan (P) at a 7% interest rate (R) with a five-year term (T) would pay total simple interest of $8,750 over the life of the loan, or $1,750 annually. In this example, the total amount you must repay is $33,750.
Compound interest is not as “simple” but is the more common way lenders calculate interest on small business loans. Just as you earn interest on interest in a compounding personal savings account, you also pay interest on interest to your lender in a compounding structure. And the more frequently the bank compounds–yearly, quarterly or monthly–the more compound interest is ultimately paid.
Compound Interest formula:
Total loan amount = P x (1 + R/n)nt
- P = principal ($25,000)
- R = interest rate (7%, or expressed as a decimal at 0.07)
- n = number of times interest is compounded per year (12, if monthly)
- t = term of loan in years (5)
Using the aforementioned example and assuming interest compounds monthly, the borrower will owe a total of $35,440.63, or $10,440.63 in interest, by the end of 60 months. But most borrowers repay their debt gradually, rather than in one lump sum at the end of the business loan’s term. As payments are made, the principal becomes smaller and the interest expense also gradually decreases. This gradual reduction of debt is called amortization.
Bottom line: Regardless of how your lender calculates interest paid, the interest rate ultimately reflects how much you will pay in exchange for the convenience of having access to the funds you need.
APR: apples to apples
The annual percentage rate (APR) offers the most accurate cost comparison among lenders. It takes into account not only the base interest rate–and whether the lender uses the simple or compound interest formula–but also any extra fees associated with the business loan.
“Think of the APR as the entire cost of the loan process, while the interest rate is just the cost of the loan,” said Sacha Ferrandi, the CEO and founder of Source Capital Funding Inc. in San Diego.
By law, lenders must disclose their APR in all advertising, even if the “interest rate” is more prominent. While an institution may highlight its interest rate, you’ll want to be mindful of all of the additional costs associated with the APR. These added costs may include but are not necessarily limited to the following:
- Application Fee. This is what a potential borrower pays to cover the processing of a loan application. This charge, generally non-refundable even if you do not move forward with the loan, may be included under the origination fee umbrella.
- Guarantee Fee. This fee is specific to recipients of 7(a) loans from Small Business Administration (SBA) lenders. The amount is calculated based on repayment terms and the dollar amount guaranteed by the SBA.
- Origination Fee. This is repayment for lender services at the outset of a potential loan, including the cost of credit checks, financial information verification and application processing. Some lenders may charge a flat fee, while others price it as a percentage of the loan. Lenders can’t charge an origination fee on an SBA-guaranteed loan.
- Processing/Service Fee. This is repayment for lender services throughout the life of the business loan, such as customer service, bill processing and other administrative charges. This may be a one-time charge but is typically included as a percentage of the monthly loan payment.
- Check Processing Fees. Another administrative charge, this may be a flat fee lenders charge in exchange for the convenience of being able to submit a loan payment via check.
- Prepayment Fees. Not included at all lenders, these are a penalty for paying off a loan early. Lenders charge this fee because they lose interest income on loans paid back early.
- Late Payment Fees. When a loan payment is paid past its due date, the lender may charge a flat fee or a modest percentage of the outstanding loan amount.
- Insufficient Funds Fees. Generally a flat fee, this is charged if the amount in the lender’s account doesn’t cover the amount of the business loan payment being withdrawn.
- Closing Fees. Similar to a mortgage, closing fees may include a number of line items, including appraisal of commercial real estate, business valuation, title insurance and other costs involved with evaluation and processing the final loan.
“The biggest difference between APR and interest rate is that the APR includes all other fees associated with the loan over time,” Ferrandi noted. “An APR is usually greater than or equal to the interest rate and is usually seen as the total cost of the loan.”
Other cost models
Depending on the type of loan or financing product, other terminology beyond business loan interest rates may apply, including factor rate and discount rate.
Factor rate. Lenders offering short-term business loans or merchant cash advances are more likely to use factor rates, which are expressed as a decimal point versus a percentage. For example, a factor rate of 1.3 on a $25,000 loan would result in $32,500 owed. Simply multiply the factor rate by the loan amount to arrive at the total amount you owe the MCA provider.
Because the MCA provider collects all interest upfront, extra or early payments will not reduce the total interest paid. Factor rates typically range from 1.1 to 1.5 and are largely determined by industry, length of business operations, sales growth stability and average monthly sales.
Discount rate. A discount rate, also referred to as a factoring fee, is often used by businesses that rely on invoicing to manage their cash flow. It has more in common with an interest rate at face value, as it’s expressed as a percentage of the total loan. The discount rate, however, is assessed weekly or monthly on invoices awaiting repayment. Invoice factoring is a form of cash advance, where a company sells their unpaid invoices to a factoring company in exchange for upfront cash that equals a certain percentage of the unpaid invoices you’ve handed over. The factoring company then collects on the unpaid invoices.
For instance, the monthly discount rate of 3% on an unpaid invoice for $100,000 would result in $3,000 in monthly expenses. Once you collect payment, your total amount received is $97,000.
As with business loan interest rates, published discount rates may also exclude fees, so the APR is still the best method of comparison.
Similar to how an individual has a credit rating, every small business has a risk profile that lenders review when determining the terms and interest rate of a loan. The riskier a business appears, the higher the business loan interest rate will be. Be prepared to discuss the following details as they relate to your loan options. The more you can improve certain factors before applying for a loan, if possible, the more options you’ll likely have.
Personal and business factors
You may come across the reference to the “five C’s of credit,” which is a helpful mnemonic device that summarizes what lenders consider when it comes to potential borrowers: character, capacity, capital, collateral and conditions. The five C’s encompass the factors below and may also include other barometers of financial health such as debt-to-income ratio.
- Personal and business credit score. A personal credit score is the most long-standing, reliable window into a business owner’s financial responsibility. The higher your score, the better you’ve done at managing credit and paying bills on time. A score of 700 or above tends to be regarded as “good” while a score of 800 or above is considered “excellent.” Generally, the better the score, the more favorable the loan terms. A business credit score is derived from similar factors, such as payment history on business credit cards.
- Business industry. Some industries such as restaurants are more prone to high turnover and are considered riskier among lenders. The more unstable or unproven an industry is, the higher the interest rates businesses in those industries will be offered.
- Length of time in business. Roughly half of all small businesses fail during their first five years. Because longevity isn’t a given, a company that has been around longer may appear less risky to many lenders and therefore can secure more favorable loan terms.
- Business revenue and profitability. Businesses with steady revenue and an established history of profitability generally are more likely to pay back their debt. Quantifiable demonstrations of financial health can go a long way toward securing financing at a lower interest rate.
- Collateral or personal guarantee. An equipment loan uses equipment as collateral; a commercial real estate loan uses property as collateral. A business owner can also leverage other assets, such as accounts receivable and inventory, to demonstrate repayment commitment and provide the lender with peace of mind.
While lenders use the above quantifiable metrics to evaluate borrowers, they are also looking for a suitable partner, said Ryan Parmenter, a former small business lender with BB&T Bank. “A lender and a business owner are both taking a risk on the other,” he said. “A lender wants to see business acumen but also the understanding that there will be risks and unforeseen scenarios that are impossible to predict.”
Unlike an auto or home loan, a business loan is typically part of an ongoing relationship. “Lenders and business owners talk frequently and are constantly reevaluating projections,” Parmenter said. “It really needs to be a partnership. On both sides, the person is staking their career, on some level, on the success of that loan.”
In addition to what was already discussed above (e.g. fixed vs. variable), there are also specific loan terms that can affect interest rates:
- Length of term. Business loan interest rates are generally affected by the loan term. Short-term loans typically have higher APRs, but you will pay less overall interest; the opposite is the case with long-term loans.
- Speed and ease of your loan. A traditional bank loan takes time to process and requires effort on both the lender’s and borrower’s side. In exchange for this due diligence, rates are typically lower. On the other hand, options from alternative lenders that provide access to funds in a matter of days will result in higher interest rates.
The financial complexities of starting a business are challenging, but not insurmountable. The first step toward finding financing is drafting a budget to help assess your needs. Reviewing your credit history and updating your business plan, if necessary, also are essential steps as you prepare to speak with lenders. Then, once you determine your priorities, whether you need quick startup cash or longer-term help with cash flow, for example, you’ll be ready to shop around with confidence for a rate that works best for your business.