Understand how interest works before diving head-first into a business loan.
There’s more to business loans than having money deposited into your account. The range of loan products available means there are also a range of interest rates and ways to calculate how much you owe. Interest on a business loan doesn’t only depend on your loan amount and term — but your business profile or what kind of collateral it can provide.
First, what is interest?
Interest is expressed as a percentage of the principal loan amount and is what you pay to be able to borrow. For example, if you borrow $12,000 with an interest rate of 5.5% over a period of one year, you’ll repay $1,055 per month. That breaks down to $55 per month in interest charges, or $660 interest over the course of your loan. You’ll end up repaying your lender a total of $12,360.
When calculating the cost of a business loan, make sure that the loan product is suited to your business profile and objectives. For example, if you plan to repay the loan quickly, choose a lender that won’t charge early repayment fees.
The loan should also suit your business’s budget. Besides the interest payments, lenders also charge a series of one-off and monthly fees for providing the loan, all of which can take a chunk out of your budget over the loan period. Make sure you take the interest rate into account when comparing your business loan options.
What interest is charged on business loans?
Here are terms you’ll see to express the different forms of interest charged on various business loan types.
- Annual percentage rate (APR). Besides interest, the lender charges various fees for setting up and providing a business loan. The APR includes all of these fees and the interest including origination and appraisal fees. It’s expressed as a percentage, which shows you a more realistic idea of what the loan actually costs.
- Discount rate. Invoice factoring companies charge this rate, which is a percentage of the invoice amount being financed. For example, if your invoice value is $3,000 and the discount rate percentage is 5%, you pay the lender $150.
- Factor rate. This is a multiplier applied to the loan amount on an unsecured fixed-term loan. A factor rate is expressed as a figure, such as 1.2 or 1.5. For example, if the loan amount is $10,000 and the factor rate is 1.2, you’ll repay $12,000 ($10,000 x 1.2).
- Early repayment fees. Repaying a loan before the end of the loan term means you stop paying the lender interest. Some lenders charge a fee to compensate for the interest they would’ve received had you continued to the end of the loan term.
Compare the rates of these top business loans
| Provider | APR Range | Min Loan Amount | Max Loan Amount | |
|---|---|---|---|---|
| LendingClub Business Loans | 9.77%–35.71% | $5,000 | $300,000 | Go to site More |
| Funding Circle Business Loans | 4.99%–26.99% | $25,000 | $500,000 | Go to site More |
| SmartBiz SBA Loans | 6.50%–8.75% | $30,000 | $5,000,000 | Go to site More |
What about annual interest rates?
The annual interest rate (AIR), also known as the effective annual rate (EAR), is adjusted to account for compounding interest over the life of the loan. It’s the amount you can expect to pay after compounding interest has been calculated, but unlike the APR, it doesn’t calculate fees.This is one of the most useful ways to compare loans. Nearly every lender will compound interest differently, but by using the annual interest rate, you can see the true cost of your loan a little more clearly.
What affects my interest rate?
The loans terms offered, including the interest you pay, are based on how much of a risk you represent. If your business is new with few valuable assets and a small annual turnover, you’ll likely pay a higher interest rate than you would if you ran an established business with a larger profit margin.
Interest rates vary depending on the lender, the lending criteria and the loan type, but in most cases lender consider the following:
- Your business profile
- Your personal and business credit scores
- Annual turnover
- Valuable assets
- Loan type and purpose
- Whether the loan is secured or unsecured
- Current and projected finances
- Time you’ve been in business
Lenders set their base rates by the market rate, which may be offered with little markup to established businesses with low risk of default. If your business is still developing, you may have to sign a personal guarantee or provide collateral. This helps lower your interest closer to the market rate, and it helps establish a relationship between you and your lender.
Fixed vs. variable interest rates
When you apply for a business loan, you’ll be offered one of three options: a fixed rate, a variable rate or a combination of the two.
- Fixed interest rate. The interest you pay on the principal is fixed for the life of the loan. Increases or decreases in the prime rate won’t impact how much you pay per month, making it easier to budget your repayments every month or quarter.
- Variable interest rate. Variable interest rates can fluctuate over the loan term. When the prime interest rate changes, so do your repayments. If it drops, business loan rates tend to drop as well, lowering your repayments. However, the prime rate can also increase, raising your repayments.
- Combination. With a combination, a fixed rate may be offered for the first year of the loan. After that it switches to a standard variable rate for the remaining life of the loan.
How to calculate factor rates
Some business loans, like merchant cash advances and invoice financing, don’t work off of a percentage model. It’s shown as a decimal, such as 1.1 or 1.5, and is multiplied by your total loan amount.
Say your lender offers you a factor rate of 1.3 for a $50,000 loan. You multiply these numbers together to get your payback total of $65,000.
Unlike interest rates, which generally applies interest over the course of the loan, a loan with a factor rate applies interest up front. This means extra payments won’t reduce the cost of your loan. If you hadn’t planned on paying off your loan early, this won’t make a difference, but it may not be the right choice for businesses hoping to lower the amount it pays in interest.
Bottom line
Business loans are a good option whether you’re just starting out or are established. Understanding how the interest on loans is calculated gives you an edge. You won’t have to worry about how much you’ll end up paying, and you can more easily compare loans that may not seem comparable at first. Once you’re ready to invest in your business, you can learn about some of your business loan options.
