Risky Business? Why Your Business Loan Interest Rate Is Higher Than an Auto Loan.

I’m going to address the elephant in the room here: interest rates. If you take an SBA 7(a) loan, you’re paying 10.5% right now. While historically it’s still pretty low, it can be a little tough to swallow after a few years hovering in the 6% range.

What makes it harder? We’re a society accustomed to billboards and ads touting personal borrowing rates, like mortgages and auto loans. These rates are usually lower than SBA loans.  And it’s not just now—it’s almost always. And you probably want to know why. 

Reason 1: Entrepreneurship Is Riskier to Finance 

Mortgage: Generally speaking, when you take out a home loan or a car loan, you’re trying to satisfy one of the basic needs in life: a place to live or transportation to work. 

With a business loan, you’re probably looking to borrow money that’s going to help you earn more money, which seems pretty essential, too, but lenders often see the situation differently.

For example, when you’re buying a home that’s intended as your primary residence, the lender may look at the need for shelter, which is an expense that most people prioritize over other expenses. Plus, if you walk away and stop paying, the lender becomes the owner of the home, which they can sell and to (hopefully) make back their investment. It all adds up to a lower risk.

Business financing: Now let’s say you own an e-commerce business and you decide you want to borrow $50,000 to have cash in the bank, make improvements to your website, invest in online advertising, maybe expand and grow. The value of what you’re doing may not be so obvious to a lender. Plus, unlike real estate, your growth plans aren’t a commodity the lender can resell if things go sour. For these reasons, lenders usually see the risk as greater. This will almost always be reflected in a higher interest rate right off the bat.

The interest rate on your loan may also be affected by other factors, including:

• The health of your industry
• The health of your company
• Your debt service ratio
• Your plan’s projected ROI

Reason 2: Income Alone May Not Be Enough to Secure Business Financing

Mortgage: Income verification is a standard part of a personal mortgage application for a reason: the lender wants to know you have a job that pays enough for you to make your monthly mortgage payments. It’s a pretty simple calculation.

Business financing: The considerations that go into vetting a candidate for business financing are far more comprehensive. For example, a lender may also take into account some of the following: 

• How regular is the revenue from the business (eg., is your business seasonal)?
• How diversified is the revenue stream?
• What % of revenue has been coming in >3 years?
• How consistent has your revenue growth been?
• How much of your revenue is profit?
• What do you have in retained earnings to cover payments?

Not all business financing considers these factors, and specific loans, financing, and lenders will have their own set of considerations, too, as will individual lenders.

Reason 3: Opportunity Costs of Business Financing Are More Nuanced

Any decision’s opportunity cost is measured by what could realistically happen if a different decision were made. 

Mortgage: Say you’re weighing whether to stop renting and buy a new home. The one you’re looking at is bigger, in a neighborhood with top-rated schools, and closer to your work. One problem: the home you want to buy will cost more than renting, and renting affords you the ability to vacation out of the country a few times each year. 

What’s the opportunity cost?

• Opportunity cost of buying a home: your out-of-country travel budget takes a hit
• Opportunity cost of renting: you miss out on the space, schools, and the time you’d save commuting

Business financing: For business owners seeking financing, opportunity cost conversations run deeper. 

Let’s say you own a house painting company — a small operation with just you and a partner — and you’re making enough to support yourselves and keep your business running debt-free, which allows you to be a little pickier about the jobs you take. You’d like to grow, but you need more supplies, equipment, and a bigger team to bid on bigger jobs. But those require upfront money that you don’t have. To grow, you’ll need to borrow.

What’s the opportunity cost?

• Opportunity cost of borrowing: you’ll lose “debt-free” status, and if business gets tight, you may be required to be a little less picky about the jobs you take
• Opportunity cost of not borrowing: your business remains stagnant and doesn’t grow

BTW, lenders have opportunity costs, too, and weigh decisions similarly. If a lender works with Business A, will that prevent them from making a loan to Business B? What would they miss out on? 

If Businesses Are a Higher Risk, Is It Still Smart to Borrow?

When you own a business, it’s a good idea to at least be open to financing. This doesn’t mean you have to do it, but if there’s an opportunity to turn $300K in equipment financing into $3M of extra revenue, then borrowing is a pretty smart move. And even if the interest rate you’re offered isn’t exactly what you were hoping for or what you’d get if you sprung for that Ferrari instead, not borrowing when your business needs to can put you in a position of not being able to take the actions that will help your business grow, thrive, or even just stay competitive. You need a new winch to finish the job? Or you need to know you have the cash available to buy supplies and pay your team before you can confidently bid on a painting contract? These are situations where having the capital available is more important than waiting for interest rates to drop again.

Think of the opportunity you’d lose without it.

_{Information provided on this blog is for educational purposes only , and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strivers to keep its content up to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.}