When looking for a business loan, it’s savvy to shop the market to ensure you’re getting a good deal. You may do so by going to a few different lenders or you may head to a lending marketplace to easily compare multiple offers in one swoop.
There are 3 major considerations for small businesses when shopping for a loan: the speed of capital, the amount of capital, and the cost of capital. Let’s talk about the cost of capital—and specifically how to approach annual percentage rates (APR). For many borrowers, their first question when looking at a business loan offer may be, “What’s the APR?” Asking about the cost of capital is an important step toward staying informed, and it signals your intention to perform your due diligence. But when you prioritize the lowest APR, you may not actually be getting the best, or the cheapest, loan for your business.
The Different Ways Loan Rates Are Calculated
APR can be an effective measurement when you’re comparing apples to apples, but not all small business loans use APR to calculate their interest rates. When comparing loan offers, you may see the cost of interest listed as an APR, a factor rate, or just generally as an interest rate.
While the variation may require a little extra work to wrap your head around at first, these different methods actually help you better understand the cost of the loan in terms of its intended use. Let’s dig into what that means.
We tend to think of interest rates in terms of APR because that’s the best way to consider personal loans. Mortgage rates, credit cards, and other personal loans all tend to be calculated using APR. In the case of a mortgage, for example, this makes sense because a mortgage often lasts for 15 or 30 years.
By contrast, you probably won’t want a business loan for that long (unless it’s a commercial mortgage). Unlike people who are limited by the fixed income of their salaries, the ability of a business to repay a loan is determined by sales and the subsequent profits. Say you took out a loan to purchase inventory. The sales from that inventory may allow you to repay the loan within months, so it makes sense for the cost of the loan to be calculated over the period of time you’ll need it instead of stretching years into the future.
APR and Loan Terms
You’ll see interest rates defined as APR most often in loans with the longest terms. In some cases, this can be the best bet for your business, but it’s not always the case. Most lenders want to see that you only have one loan at a time. If you take out a second loan, that may violate the terms of your first loan, which in turn may hurt your credit and/or prevent you from qualifying from other loans in the future.
Businesses have changing capital needs, so it often makes the most sense to look at your loan not in terms of “what is the lowest monthly payment” but “how quickly can I reasonably repay this loan.” When you choose a loan with a shorter term, the advantage is that you can free up your financial obligations quicker. That way, the next time your business needs financing, you’ll have the flexibility you need.
A note for borrowers who may have already taken out multiple simultaneous loans: Don’t worry, and you’re not the only business owner in this position—not by a long shot. Loan consolidation is one strategy that can help. To get the best advice for your specific situation, talk to an expert about your option.
Look Out for Additional Fees
When a lender calculates the interest rate on your business loan, they may or may not include additional fees. For example, you’ll also want to investigate if the lender charges an application fee, an origination fee, or any other fees associated with the cost of the loan. Have those been calculated into the APR? If not, how do those other fees affect the total cost of the loan?
In some cases, you’ll find that the loan with the lowest APR comes with higher fees that can make it the more expensive option in the long run.
A Lower APR May Have Higher Up-front Costs
Ask about the origination fee, the sum the lender charges upfront to cover the cost of issuing the loan. Some small business loans with a lower APR may come with a higher origination fee. Your business may have lower payments on the loan over time, but ask yourself if you can handle the higher up-front costs before choosing this loan option.
Watch Out for Introductory APR Offers
Some lenders will offer an extremely low “introductory APR,” to attract borrowers. Once the introductory period ends, the APR usually increases by a substantial amount. There are instances where this can still work in your favor. A 0% introductory APR credit card, for example, can be used to make a large purchase and then repaid within the introductory period. An increase in APR may not be a deal-breaker for your loan either, but you don’t want to be caught by surprise.
How to Determine the Best Loan Rates for Your Business
To secure the best interest rate for your small business loan, you want to take a holistic approach when comparing loans. Here are some of the components and questions you should consider:
- What do you need the loan for and how long will you need it?
- What are the other fees associated with the loan?
- What is the true cost of capital for the loan?
- How does the cost of the loan compare to the income your business will generate with this increased capital?
- If accepting a higher interest rate means qualifying for a larger amount, will that help your business?
- If accepting a higher interest rate means getting the capital faster, will that help your business?
Sometimes, it boils down to qualifications. If you qualify for a loan with a higher interest rate, that can be a greater benefit than a low-APR loan you don’t qualify for. Do what makes the most sense for your business and not just what sounds like it makes the most sense. You got this.