Understanding Business Loan Interest Rates

May 2, 2019

Understanding Business Loan Interest Rates

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Loan interest rates can be a confusing topic for many entrepreneurs. This quick guide will familiarize you with the most common metrics for determining the cost of your loan and provide you with valuable tools to help you choose the right loan option.

1. Before you shop for a loan…

So you need a loan. You could go straight to the bank and ask for a loan, but it will (literally) pay to hold off just a bit. Here’s why: When you ask for financing, the lender will be very interested in how much capital you’re bringing to the table when seeking a loan. So if you stroll up to the bank with a wad of $20 bills, plan on getting denied.

On the other hand, if you can demonstrate that you’re fully invested in your business and its success, you’ll have a much easier time getting approved. This is why you should spend some time creating a documented business plan, rounding up revenue reports and bank statements, and estimating financial projections. Most lenders will ask for your financial data, so be sure to have it on hand.

Before you go loan shopping, you’ll need to decide how much money you’ll need (a lender won’t be amused if you ask for a “medium-sized amount”). In case you’re wondering, the Small Business Administration (SBA) reports the median small business loan is in the neighborhood of $140,000. And most small business loans don’t go higher than $250,000.

Allowing time to consider your anticipated costs and take full stock of your current capital is crucial. Identifying a clear amount in advance will undoubtedly save you both time and effort.

After identifying several loan options that potentially match your needs, you’ll need to carefully evaluate the key elements of each loan. For example, pay attention to the amount financed, funds disbursed, total repayment amount, expected term, and frequency of payback. Rush through this stage and you may be in for a rude awakening when the payment structure isn’t what you anticipated.

2. How much will the loan cost?

One of the first things any reasonable entrepreneur is going to look at when considering a loan option is the cost. The problem is loans don’t come with a price tag like a toaster or a vacuum. Lenders use multiple metrics, and some are not readily accessible to borrowers.

The interest rate is a vital way borrowers begin to ascertain the cost. It’s the percentage a lender will charge each year for the financing you’ll receive. You can calculate it by identifying a loan’s periodic interest rate, then multiplying the rate by the number of periods the rate would be applied in a given year.

Some business owners make the mistake of basing decisions solely on the interest rate. While a loan’s interest rate is important, it’s only one piece of the puzzle. Here’s a breakdown of the 4 most common pricing metrics you should also be monitoring:

  1. Total Cost of Capital (TCC): If you’re looking for a price tag on a loan, the TCC is about as close as you’re going to get. This metric adds up all interest, fees on the loan that don’t charge interest, and any additional fees. The resulting dollar amount is extremely helpful when comparing options.
  2. Annual Percentage Rate (APR): Contrary to popular belief, this metric is not the same as the interest rate. Anyone who tells you otherwise is either confused or dishonest. A loan’s APR is the yearly cost to you, including any transaction fees. The amount is expressed as a percentage of your principal. The APR helps you identify the cost so you can determine how much you can afford and what loan product will work best for your business. Many lenders use APR when quoting their loans, as it’s a user-friendly metric that makes it easier for you to compare multiple loan options. Be aware, however, that APR never tells the full story. For example, it doesn’t include the effects of compounding.
  3. Average Monthly Payment: While the TCC gives you a long view of a loan’s cost and APR boils it down to the annual level, the average monthly payment is an important metric because it provides the exact amount you’ll be responsible for each month. This amount can be deduced for any loan, even if the terms require daily or weekly payments. Your average monthly payment enables you to see just how much the loan repayment will impact your finances in the near-term. If you can afford the average monthly payment, you can also afford the TCC and APR.
  4. Cents on the Dollar: Metrics like TCC provide a macro view, so here’s the micro. Cents on the dollar is a unique perspective on a loan’s cost because it shows how much interest and fees you’ll be paying for each dollar you borrow. On its own, this metric is fairly useful. When combined with the rest of the loan metrics, it’s essential to making an informed choice.

3. Factoring in factor rates

Lenders often use factor rates when quoting their loan products. This number is for your convenience, as it clearly shows how much you’ll be required to pay back to the lender. The metric is expressed as a decimal figure for all loans, whether they’re a short term loan or one paid off over 35 years.

With most loan products, the factor rate will be the amount you need to pay back divided by the amount funded. The formula is different for merchant cash advances, due to the unique way this type of financing works. With a merchant cash advance, you get money by borrowing against future earnings. So the factor rate is the purchase amount divided by the advance amount.

4. Comparing loan options can be a doozy

The bad news is that lenders’ disclosures vary wildly, making it hard to see how one loan’s metrics stack up against another option. It’s kind of like trying to decide which is the best minivan to purchase for your family, but the Honda Odyssey has listed its price, features, and gas efficiency in a different way than the Toyota Sienna or Kia Sedona.

Even when you’re able to find comparable elements, there is still the risk of hidden fees that skew the data. Again, it’s kind of like buying that family minivan and the dealer has hidden things like a $400 “tire inflation” fee in your contract. In the financial world, lenders may include early repayment fees, late fees, or processing fees. Some of these fees are legit, but some are not. It always pays to take your time and review things line-by-line.

“You may feel like you have time against you, but it’s okay to slow down a bit,” says Business.com of the loan review process. “The absolute worst thing you can do is rush into this. Prematurely selecting a loan, only to figure out a month from now that you chose the wrong one, can be devastating to your business. Be patient and carefully evaluate all of your options before proceeding too far in the process.”

The ILPA strives to improve fair lending

The Innovative Lending Platform Association (ILPA) decided to create a reliable resource for entrepreneurs that addresses the array of loan products and the distinct metrics of each. In conjunction with many of the industry’s most prominent lending platforms, they launched a comparison tool named SMART Box™ (it’s an acronym for Straightforward Metrics Around Rate and Total cost).

“Access to capital is a top priority for NSBA and we appreciate how SMART Box™ allows small businesses to more fully assess and compare lending options,” says Todd McCracken, president and CEO of the National Small Business Association. “This type of price transparency, along with best practices like the ones adopted by the Coalition for Responsible Business Finance (CRBF), will help solidify the trust between non-bank lenders and small businesses.”

The most important aspect of SMART Box™ is its encouragement of common language and understandable disclosure standards. When small business owners use tools like this to compare pricing metrics, they’re better able to make informed decisions.

Because there are different types of financing, it stands to reason there are also different versions of the SMART Box™ tool. Each is tailored to a family of loan products that share similar features. Currently, there are 3 versions:

Although these customized tools are designed for maximum clarity, they’ll never replace the need for due diligence. Consider them an indispensable complement to your careful review of a lender’s disclosures.

If you’re struggling to compare loan options and understand the pros and cons of each, head to the Lendio marketplace. Once you answer a few questions about your business, one of our personal funding managers can help you choose a loan that fits your needs and budget. And there’s no cost or obligation to explore your options.

5. What if interest rates rise?

As physics has proven time and again, what goes up must come down. Interest rates certainly have their peaks and valleys, though to some entrepreneurs it may seem as though they’re constantly going up.

Although it appears the Fed may not raise rates any time soon, let’s assume for the sake of conversation that interest rates are going to continue climbing. The increased rates would make financing cost more, while also bringing positive dynamics to the economy. Here’s how Lendio CEO Brock Blake explained it in a Forbes article:

“Another potential long-term benefit of rising interest rates? Improved margins. The underlying driver of a rate increase like this is inflation. When there’s mild inflation, prices for goods and services tend to move higher, giving small businesses room to increase their prices over time. With better cash flow and higher rates, you can improve your margins, leading to additional flexibility and breathing room.”

So don’t let the specter of rising rates keep you from your business goals. If you’re strategic and shop around, you’ll be able to find a loan product that not only makes your heart sing but also helps deliver powerful benefits to your bottom line.

About the Author

Grant Olsen

Grant Olsen

Grant Olsen is a writer specializing in small business loans, leadership skills, and growth strategies. He is a contributing writer for KSL 5 TV, where his articles have generated more than 6 million page views, and has been featured on FitSmallBusiness.com and ModernHealthcare.com. Grant is also the author of the book "Rhino Trouble." He has a B.A. in English from Brigham Young University.

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