Entrepreneurs, looking to expand their businesses or perform day-to-day operations, often opt for business loans. But, it is very important to choose the right financing option, considering the requirements and current financial condition of the business. Also, before picking a business loan, one must always understand the interest costs and fees attached to different financing options. This helps a business owner not only save money but also avoid various harassment and financial stress while repaying the borrowed amount. Research says, the average loan interest rate in 2022 ranges from 3.19% to 12% at banks. Now to start with, what is the ‘interest rate’ on a business loan? Technically, the interest rate on a business loan is the amount the lender charges the borrower for funding. An interest rate is generally expressed as a percentage of the principal amount of the loan. There are two types of interest rates: simple and compound interest rates. Simple interest rates consider just the amount borrowed, the yearly interest rate and the term of the loan, whereas, in the case of compound interest rates, borrowers are charged interest on the initial principal amount along with accumulated interests, if any. Loans can compound daily, weekly, monthly or even annually.
However, the rate often depends on various factors. The factors on which the interest rates of banks depend are:
- Bank loans primarily require high credit scores and strong trade history. Therefore, start-up owners or entrepreneurs with a low credit history are less likely to get approvals from banks.
- Interest rates often vary with the type of bank the borrower has applied from. The rates of private banks are different from that of government banks. Often, SBA loans, backed by the U.S. Small Business Administration, provide funding at reasonable interest rates. In 2022, SBA loan rates range from 7% to 9.50%.
- Banks often provide loans at comparatively lower interest rates when the borrower agrees to secure the loan with business collateral, which is, mostly, either inventory or property. This reduces the lenders’ risk as they can seize the asset and recover the lent money, in the case of defaults.
- The current market condition is also one of the influencers of the interest rates on business loans. Besides, the total amount borrowed and the length of the repayment period also determine the interest rates.
Flexible Repayment Structure
When it comes to a business loan, interest rates can be either fixed or variable. In the case of a fixed interest rate, the borrower needs to pay a fixed monthly amount till the entire amount is repaid, whereas, finances with a variable interest rate require the borrower to pay as per the current cash inflow of the business. In both cases, there are some advantages and disadvantages. As every business has unique requirements, an entrepreneur needs to analyze which type of interest rate is most convenient for him. A small business loan generally comprises an origination fee or processing fee, which is an upfront amount charged for processing a new loan, an underwriting fee, which is collected to review and verify the documents provided by the applicant, and a closing fee, which is associated with servicing the loan like a business valuation, loan-packaging fee. In thecae of SBA loans, the guarantee fee ranges from 0% to 3.75%,depending on the size of the loan, and the annual service fee is between 0% to 0.55%. To compare rates of multiple financing options, the interest rates need to be converted to APR. Annual Percentage Rate (APR) is the payable interest rate per year, that includes all the fees, ranging from origination fee, and application fee to closing fee. It gives the borrower a comprehensive idea of how much the loan will cost him. Another way in which lenders quote business loan rates is Factor Rate. Slightly different from the typical Interest Rates, Factor Rates are expressed as decimal figures, that usually range from 1.1 to 1.5. The Factor Rate needs to be multiplied by the total loan amount to get the actual cost of the loan. In the case of factor Rate, the lenders charge all of the interest upfronts, while originating the loan. Loans with Factor Rates are non-amortizing and hence, the cost doesn’t change even after the loan amount is paid back early or more than the minimum payment is made. These are generally associated with Merchant Cash Advances (MCAs), which are often considered expensive compared to other non-traditional financing options. Interest Rates, Factor Rates and APR are considered the three primary cost-related terms that entrepreneurs often come across while applying for business finance. Among the other popular pricing models is the Discount Rate, used by invoice factoring companies. It is a weekly or monthly percentage the lenders assess on the face value of the borrower’s invoice or the advance.
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