Small Business Loan Rates Guide
When your business needs capital, your focus is probably how to find a lender and how to qualify for a small business loan. Small business owners with less-than-stellar personal credit scores might focus so much on how they are going to find an alternative lender and qualify for a loan that they do not think much about things like fees and interest rates.
Ignoring the interest rate on your loan, plus the fees, is a costly mistake. The interest rate that lenders charge is how they make their money. It is the price you pay for the funds that you have borrowed. If your lender charges you a high rate, borrowing and repaying that money could hurt your business.
It is a good idea for every small business owner to thoroughly educate themselves about interest rates so they can evaluate a loan’s potential impact on their business.
Types of Interest Rates
Business loans typically charge one of four main types of interest rates. They are;
- Simple interest rate
- Compound interest rate
- Annual percentage rate (APR)
- Factor rate
The simple interest rate is what you will most likely see on a lender’s website or be quoted on the phone. It is the amount charged on the principal that you are borrowing. The rate is tied to time, and you will be quoted a daily, weekly, monthly or annual rate depending on your loan. The only three factors used to calculate the simple interest rate are; interest rate, amount of money borrowed, the loan’s term.
A compound interest rate charges interest on both the loan’s original principal amount and any accumulated interest. Some alternative and short term lenders will offer loans which compound daily, with a daily payment that includes interest on accumulated interest. It can be a difficult concept to grasp, but essentially it means that you will pay more interest over the loan’s term than if you had a loan with a simple interest rate.
The annual percentage rate, or APR, is a more accurate reflection of the loan’s total cost to you. This is because APR includes your interest rate, loan fees, and the term when calculating the rate. A shorter term loan will have a higher APR, however, just because the interest is amortized (or spread out) over a more condensed time period. But, depending on the rate, you could actually pay less in total interest dollars by the loan’s end than a lower APR but longer term loan. Many lenders will provide you with the APR in their loan package, but if you do not see it in your loan application and forms you can request that they provide it.
More common in short term loans or merchant cash advances, the factor rate is an amount that is charged on your loan up front. Unlike a simple or compound interest rate, where the interest is amortized over all the loan’s payments, the interest is charged up front and packaged into the life of the loan and payment schedule. For example, a factor rate of 1.4 on a $100,000 loan means that you will pay $40,000 in interest. In a loan with a simple interest rate, that $40,000 would be spread out over the monthly payments. If the loan charges a factor rate, you pay $40,000 up front and do not receive a refund if you pay off the loan in full before the end of its term.
The interest rate you receive greatly influences the loan’s long-term cost to your business. It can turn a wise business decision into one that harms your financial condition.
Loan Fees that Impact APR
Loan fees impact APR, and therefore should be included in a discussion of interest rates. If two lenders are charging the same interest rate but one lender charges significantly more fees than the other, the APR can become a differentiating factor when deciding where to fulfill your capital needs.
Common loan fees include;
- Application fee
- Origination fee
- Processing fee
- Service fee
- Prepayment fee
- Check processing or bank withdrawal fees
- Late payment fees
Lenders may charge non-refundable application fees upfront to ensure that you are serious about needing the capital. They do not want to waste their time reviewing an application for a borrower who is not serious and may only be using them to bargain for a better rate with another lender.
An origination fee of 1-2%, but which can rise as high as 9%, of the loans’ principal is often deducted up front. This fee recaptures the cost of the time and effort spent processing the loan. It is sometimes called a processing fee, or a processing fee can be charged on top of it. This fee represents the time spent reviewing and approving your application and can rise up to 5%.
Servicing your loan costs a lender in terms of billing, collecting payment and offering customer service. You might pay a periodic, usually annual, servicing fee on your loan.
When a lender decides to lend to you they have calculated the profit they expect to make on your loan. This profit is partially based on the length of time you will be repaying it. Therefore, if you prepay, they do not make as much money. Some lenders will put a prepayment fee, or penalty, in the loan to compensate for the interest they will not receive should you prepay.
This prepayment penalty is often 3-5% of the loan’s principal, but sometimes it follows a sliding scale. If you prepay early in the loan’s term, your prepayment penalty will be higher than if you prepay much later. That is because there is a higher amount of interest that they will miss out on receiving if you prepay earlier.
Clearing houses which process automatic bank withdrawals and checks charge lenders fees to clear this money. Lenders are not charities; if they are charged a fee they will do their best to pass it along to you. If you pay by check, you could be charged a $25 fee. Automatic withdrawals carry less risk for lenders, so they will typically charge a lower fee for them.
As a small business owner monitoring their credit you know that late payments can have a negative impact on your score. But late payment fees can also add up quickly, and you should do your best to avoid them.
Not all lenders charge all of these fees. There can be a wide range in the percentage of principal charged, too. A prepayment fee of 3% on a loan of $10k would be only $300, whereas a prepayment fee of 10% would be $1,000. As a small business owner, you should not only know your APR but also compare fees between lenders when making your borrowing decision.
Business Loan Rates by Lender Types
Because lenders compete with each other to lend money, rates for specific loan types tend to stay within a range. Note that if the Fed Funds Rate goes up, you should expect to see a corresponding upward shift in these rates. These are the current ranges for APR’s offered by the two types of lenders, traditional and alternative. Remember that the APR is the true cost of the loan because it includes all fees.
|Traditional Bank||Alternative Lender|
|Long-Term Loans (5 Years or More)||4-13%||N/A|
|Lines of Credit||Prime + 1.5% –||8-80%|
|Equipment Financing||5.50% –||8-40%|
|Invoice Financing||0.5%/week – 5%/month||13-68%|
|Merchant Cash Advance||N/A||20-250%|
Rates will also depend on if the loan is secured by collateral, such as with an equipment financing loan, or are unsecured. Alternative lenders often charge much higher rates than traditional lenders. They are taking on more risk, lending in a shorter timeframe, and working with less-qualified borrowers. Traditional banks charge less but rarely work with borrowers who have credit scores below 700 and can take several months to approve a loan. There are distinct advantages to working with alternative lenders, particularly if you need cash quickly.
Factors which Influence the Interest Rate You’ll Pay
The specific interest rate that you will pay depends upon many factors, including; your personal credit score, your business’ revenues and profitability, the length of time you have been in business, and your industry. This is why, early in the application process, most lenders will quote a range of interest rates rather than one number. Until they have delved deeper into each of these considerations, it is risky for them to lock in a rate. The lender’s underwriting department determines your risk, and the rate you pay reflects the risk of not being repaid when a lender gives you funds.
The overall loan market can also influence rates. Lenders pay to borrow funds from the Fed or other banks. If they do not then, in turn, lend out that money to make a profit on the net interest margin, they are losing money. It incentivizes them to lend. Strong demand from borrowers leads to higher interest rates because lenders have their pick of places to lend and make money. Weaker demand tends to push interest rates downward.
That Federal Funds rate matters to you as a small business owner. It is the rate that the Federal Reserve charges to commercial and other types of banks to borrow from them. Therefore, it is the base of the rate that you will pay. If the Fed charges a bank 5% to borrow money from them, and they lend it to you at 7%, the lender’s net interest margin is 2%. That is their profit. The more credit-worthy your business, the closer your interest rate will be to the Fed Funds rate.
The speed that you need funding will drive your interest rate higher. Look at it this way; if the lender is giving you the money in one to two days they have less time to verify your credit-worthiness or your repayment ability. Therefore, they’re taking on more risk and thus will charge an interest rate that reflects this; the shorter the time between applying for the loan and receiving disbursement, the higher the interest rate that you’ll pay.
Whether or not the loan is a fixed rate or variable rate can also significantly impact the amount of interest you pay. With a fixed rate loan, your interest will not change throughout the loan’s term. Loans such as lines of credit, where the loan balance can fluctuate depending on what you have withdrawn, typically use variable rates. Variable rates are tied to Prime, the Fed Funds Rate or the rate the highest quality borrowers receive, plus a percentage. If you have a variable rate loan and the Fed Funds Rate fluctuates significantly over the loan’s life your total interest costs could be much higher than anticipated.
A savvy small business owner knows that the price they pay to access capital impacts their business. It will dictate their payment amounts. With a variable rate loan, a change could cause a regular payment amount to go up significantly and trigger cash flow issues. Educating yourself about the types of interest rates, how fees feed into interest rates, and what you can expect to pay as the cost of capital, is a part of learning to manage the financial side of your business.