As a small business owner, you have likely considered the potential of taking out a loan to invest in growth. To make an informed decision about your loan options, it is crucial for entrepreneurs to understand the factors that affect how much interest they will be charged on any borrowed money.

In this guide, we shed light on what goes into calculating business loan interest rates and provide helpful tips for evaluating the best financing product for your unique situation. Whether you're looking to put more capital towards operations or expand in new directions, understanding how interest works can save you time and money – investments worth their weight in gold.

What is interest?

In simple terms, interest is the the “rent” you pay to use someone else’s money. When a bank, credit union, or online lender provides you with a loan, they’re taking on the risk that you might not pay it back. In exchange, they charge interest to cover that risk and earn a return on their capital.

Interest is usually calculated as a percentage of your total loan balance and paid monthly. Interest is a part of short-term loans like credit cards, as well as longer-term loans like those for purchasing commercial real estate. You could also be generating interest income on any savings or investment accounts held by your business.

Interest rates vary from loan to loan and are determined by many different factors. Your lender will consider your credit score, your industry, the profitability of your business, and more when determining your interest rate. It’s a good idea to compare loans based on the annual percentage rate (APR). This calculation considers the interest rate, loan amount, term, repayment, fees, and more to give you a more comprehensive comparison between loan products.

What is Amortization?

Amortization is just a fancy word for spreading out your loan payments evenly over time. Most standard business term loans use simple interest with amortization, which means your payments go toward both principal and interest.

Most loans will be set up so that you pay the same amount every month. This is usually referred to as your "monthly payment." At the start of the loan, a bigger portion of your payment goes toward interest. Over time, as your balance shrinks, the interest portion gets smaller and more of your payment goes toward principal.

What’s an interest-only period and how does it work?

An interest only period is just a set time frame where you don't pay any of the principal on your loan.

A loan can include an interest-only period to give you a financial cushion to support your business during a start-up period, seasonal change, or construction and renovation phase. This period might occur for the first 6-12 months of your loan term. During this transitional period, rather than making full principal and interest payments, you’ll make interest-only payments, and the interest paid each month is only on the amounts already distributed. After the pre-determined interest-only period ends, you’ll begin to make full principal and interest payments.

What’s the difference between a fixed interest rate and a variable interest rate?

Loans can either have fixed or variable interest rates that will impact your cost of borrowing over time.

Fixed interest rates

If you have a fixed-rate loan, the interest rate stays the same throughout the life of the loan, regardless of how interest rates change outside of the loan. This can be beneficial when the rates are lower because you’ll lock in your loan at a lower rate until the loan is paid in full.

If you are looking for a more predictable option, a fixed-rate loan can give you just that. Your interest rate won’t change during the life of your loan and your monthly payment amount will be the same each month.

Variable interest rates

With variable-rate loans, the interest rate can change throughout the life of the loan, including changes due to economic conditions. Variable rates have a rate timeline set by your lender to determine when your interest rate is recalculated, such as monthly, quarterly, or annually.

In either case, if interest rates fall you can always try to refinance your debt into a lower-cost loan.

Why Understanding Interest Matters

Ok that was a lot of information, but why is it important? Most loans you see will have pretty similar terms, what difference does a percentage point here or there make? All that really matters is making sure you get the loan, right?

Wrong.

At first glance, a few percentage points might not seem like a big deal. But over the life of a loan, even a small difference in rates can add up to tens of thousands of dollars.

For example:

• A $500,000 loan at 8% over 10 years will cost about $227,000 in interest.

• That same loan at 10% will cost about $290,000 in interest

  
  

That's an extra $63,000 of interest cost!

That’s money that could be invested back into your business if you're diligent about selecting the right loan for you.

Types of Business Loans and Their Interest Rates

As a small business owner, you may have faced the need for additional capital to invest in your business. In these situations, taking a business loan with an interest rate below 25% is often not considered predatory. It's important to view these loans as an investment into your business rather than a burden.

Many of us are used to seeing the higher interest rates for credit cards and historically lower interest rates for personal loans like mortgages and car loans. It can be confusing when trying to figure out what type of interest rate to expect for a business loan. The two main types of business loans are secured and unsecured, each with its own set of associated interest rates.

Secured Loans

Secured business loans require some sort of collateral such as equipment, inventory, or real estate to guarantee that the debt will be repaid. If you don't repay the loan then the lender is entitled to take possession of the collateral you've pledged. In this case, the interest rate will usually be lower due to the added security.

Unsecured Loans

Unsecured business loans don’t require collateral but rely on personal creditworthiness for repayment. Usually, unsecured loans have higher interest rates due to the higher risk of default associated with them.

The Factors that can Determine Your Business Loan Interest Rate

Lenders consider several key elements when determining the rate, including your credit score, the amount of collateral you can offer, your industry, and the size and profitability of your business. A strong credit score and valuable collateral can help you secure a lower interest rate, while a high-risk industry or longer loan terms may result in a higher rate.

By understanding these factors and working to improve your credit and collateral, you can position yourself for a better loan rate and save money over time. At the end of the day, choosing the right loan at a competitive rate can be a critical factor in the success of any business, so it pays to do your research and work with a lender who can help you achieve your goals.

How to Shop for the Best Business Loan Interest Rate

Securing the best possible interest rate for your business loan can save you a significant amount of money over the life of the loan. Here's a step-by-step guide to help you navigate this process.

Step 1: Understand Your Business's Financial Health

Before you begin shopping around, take a deep dive into your business's financial health. Review your balance sheet, profit and loss statements, and cash flow. This will give you an accurate picture of your financial standing and help you determine how much you can afford to borrow.

Step 2: Identify the Right Type of Loan

There are various types of business loans available, each designed to meet specific business needs. From term loans to lines of credit, it's crucial to understand the differences and identify the type that best suits your situation. Check out our guide on the different types of business loans.

Step 3: Reach out to Multiple Lenders

Different lenders have different lending strategies. This can include industry preference, target loan size, and ideal structure and terms.

Spend time researching different banks, credit unions, and online lenders to understand what they offer. Once you've identified potential lenders and the right type of loan, reach out to multiple of them!

Draft a concise email describing your business and the type of loan you're seeking. Then send that email to 5-10 lenders. If you don't get a response, don't be afraid to pick up the phone and call the loan officer directly.

Step 4: Don't Get Discouraged

Sometimes your company might be a fantastic business but just isn't the right fit for a specific lender. The bank may have overinvested in your industry the prior year and is trying to diversify their balance sheet. If you only speak to one lender, you'll never know!

Speaking to multiple lenders will give you a more options and a better overall picture. More options are always better!

Step 5: Negotiate Your Rate and Terms

Don't be afraid to negotiate with lenders. If you have strong financials or a solid relationship with the lender, they may be willing to offer a more favorable rate.

If you've spoken to multiple lenders you'll have a better picture of the type of loan terms are available and the best opportunities to negotiate.

Step 6: Read the Fine Print

Before signing any loan agreement, ensure you understand all the terms and conditions. If something isn't clear, ask for clarification.

Tips for Negotiating the Best Possible Interest Rate

Remember, negotiating a business loan is not just about getting the funds you need; it's also about ensuring that the loan terms are manageable and beneficial for your business in the long run.

• Understand Your Business's Risk Profile: Lenders typically base their interest rates on the perceived risk. The healthier your financials appear, the better chances you have of securing a lower rate.

• Be Prepared: Identify what is crucial and non-negotiable for you and what areas you can compromise on. The more prepared you are, the stronger your negotiation position will be.

• Establish a Negotiation Strategy: Knowing your financial situation, understanding the lending market, and identifying your ideal terms can guide your negotiations and prevent you from settling for less than what your business needs.

• Negotiate With Your Lender: Once you've been approved for a loan, don't hesitate to negotiate for a lower interest rate. If you have strong financials or a solid history with the lender, you may be able to secure a more favorable rate.

Mistakes to Avoid When Applying for a Business Loan

Navigating the process of applying for a business loan can be complex, but avoiding common pitfalls can increase your chances of approval. Here's what you need to keep in mind:

Lack of Preparation

Entering the application process without a clear understanding of your financials and business plan can lead to rejection. Ensure that you have a solid grasp of your business's financial health, including cash flow, balance sheet, and profit and loss statements.

Not Researching Lenders

All lenders are not created equal. It's essential to research different lending institutions to determine which one best aligns with your needs. Look at their loan terms, interest rates, and requirements before making a decision.

Only Talking to a Single Lender

Research is critical but nothing will compare to speaking with a lender directly. A single lender's feedback on your business won't necessarily reflect every lender's position. Your business is unique and so are your lending needs — make sure you find a lender whose loan offerings match your priorities.

Applying for the Wrong Type of Loan

There are various types of business loans available, each designed to meet specific business needs. Understand the different options and choose the one that best suits your situation.

Not Reading the Fine Print

Loan agreements can be dense and filled with jargon. However, it's crucial to understand all the terms and conditions before signing on the dotted line. If something isn't clear, don't hesitate to ask for clarification.

Questions to Ask Before You Take Out a Loan

Taking out a business loan is a significant decision that can impact your company's future. It's crucial to make an informed choice. Here are five key questions you should ask before signing on the dotted line:

1. How Much Do I Really Need?

Before applying for a loan, calculate the exact amount you need to achieve your business objectives. Borrowing more than necessary can lead to unnecessary debt.

2. What is the Interest Rate and APR?

Understanding the interest rate and Annual Percentage Rate (APR) is crucial. The APR includes both the interest rate and any associated fees, giving you a clearer picture of the loan's total cost.

3. What Are the Repayment Terms?

Repayment terms can vary widely. Ensure you understand the payment schedule, the duration of the loan, and whether there are penalties for early repayment.

4. Are There Any Additional Fees?

Some lenders charge additional fees like origination, processing, or late payment fees. Be sure to ask about these upfront to avoid surprises later on.

5. What Happens If I Can’t Repay the Loan?

It's crucial to know the consequences of failing to repay the loan. This could include damaged credit or even losing collateral tied to the loan.