What Is a Business Loan Interest Rate?
A business loan interest rate is the amount of money a lender charges for the use of the capital lent in the loan as a percentage of the overall principal. Because there are many types of business loans, a business loan interest rate often depends on the loan type.
Lenders consider factors like a business’ profitability, operational history, and credit score when determining a loan’s interest rate.
There are four key points to remember about business loan interest rates:
- The amount of interest you must pay will depend on the business loan terms, which you’ll work out with your lender in advance.
- While the business interest rate represents the cost of borrowing, you also must pay back the principal amount you borrow.
- Lenders usually determine business loan interest rates based on current banking interest rates.
- A business loan interest rate also depends heavily on the credit score of both the business and its owner(s). That makes it important to maintain strong business and personal credit scores.
What Are the Main Types of Interest Rates?
When discussing business loans, lenders can use confusing terms and acronyms. Reviewing the following terms will help you understand more about interest rates and how lenders calculate them.
Annual Interest Rate
The annual interest rate (AIR) is the yearly interest rate that comes before other borrowing costs like application fees, origination fees, and closing fees.
- Expressed as a percentage, this rate is calculated by taking the total interest and dividing it by the loan amount and the number of years borrowed.
- Many small business owners find it hard to calculate the annual percentage rate (APR) of declining-balance loans, so they instead use the AIR.
Annual Percentage Rate
Usually higher than the AIR, the APR is the annual interest rate that also includes the monthly upkeep charges and origination fees. When applying for a business loan, make sure you ask about and understand the loan’s APR.
- Calculated by the financial institution providing the business loan, the APR represents the loan’s total cost on an annual basis.
- When looking to fund business growth, business owners should consider a loan’s APR as a part of the overall cost.
The prime rate is the interest rate lenders charge to business borrowers with the most preferred credit scores. The U.S. prime rate is the interest rate banks use to help them calculate the interest on loans, with the exception of mortgages.
Currently, the U.S. prime rate is 3.25 percent. If a lender tells you a business loan interest rate is “prime plus 4 percent,” your interest rate would be 7.25 percent as long as the prime rate remains 3.25 percent. If the prime rate increases, you’ll pay more in interest. If the prime rate decreases, you’ll pay less interest.
- The prime rate is correlated to the federal funds rate set by the Federal Open Market Committee within the Federal Reserve System.
- The prime rate is equal to the federal funds rate plus 3 percent. If the current federal funds rate is 2.25 percent, for example, then the prime rate will be 5.25 percent.
A factor rate is a rate typically used by lenders to determine the interest payments for cash advances and short-term loans instead of an APR. Importantly, factor rates are fixed — unlike interest rates, which can fluctuate. If you happen to pay off a loan with a factor rate early, it won’t save you money on the interest. In contrast, early payment of a loan with an interest rate will usually save you money because you’ll reduce the principle and thus also reduce the rate of interest applied.
- Also known as buy rates, factor rates usually are expressed as decimals (e.g., a 1.4 factor rate) and often fall between 1.1 and 1.5. Lenders multiply this decimal figure by the total amount borrowed to determine the overall amount you must repay minus the loan fees.
- Associated with high-risk lending products, factor rates depend on a small business’ industry, year in operation, sales stability, and average monthly credit card sales.
What Factors Affect Business Loan Interest Rates?
Despite all the jargon associated with business loans, two key factors affect business loan terms: risk and return. Obviously, lenders want to lose as little money as possible. Their return on a business loan depends on the business owner repaying the loan on time.
- Lenders may charge more fees and interest if they have any doubts about whether or not a business owner will repay the loan on time.
- If a business owner (the borrower) seems like a risky investment, they’ll receive less attractive interest rates on business loans.
Read on for more information about several other factors that also can affect business loan interest rates.
Your Business and Personal Credit Score
As with any loan, business loans require a thorough review of the credit score for both the business and its owner(s). That makes it important to maintain strong business and personal credit scores.
Here’s what you need to know:
- The better the credit scores of both the business and its owner, the more likely the owner will be to secure approval of their business loan.
- A poor credit score will negatively impact a business owner’s chances of securing a business loan with a good interest rate. A lender likely will increase both the interest rates and fees on a business loan to such a borrower.
Your Business Plan
If a business owner applies for a business loan through an alternative lender instead of a bank, they can rest assured that their interest rate won’t be based solely on their credit history.
Here’s what you need to know:
- Lenders only offer business loans to business owners they deem worth the risk. For this reason, business owners should submit a comprehensive, detailed, and professional business plan along with their loan application.
- Providing a detailed business plan won’t reduce your loan costs, but it can help a lender gain an understanding of the business in which they may choose to invest.
Your Down Payment Size
If a business owner wants a business loan, they also must show the lender they’re committed to the business. This means placing their personal assets on the line with a down payment on the loan. The bigger the down payment, the better the interest rate in general.
Here’s what you need to know:
- A business owner may need to provide a lender with a large down payment or a significant amount of personal equity as collateral to convince them they can repay the loan. The higher the value of the collateral offered by a borrower, the more benefits they may get with the business loan. For example, a higher collateral value gives a bank the opportunity to offer a larger loan amount because it’ll face a lower risk.
- Business owners who apply for a business loan without a down payment or collateral should expect banks to charge them very high interest rates and fees. In some cases, a bank may even require a shorter repayment period than a business owner would prefer. Such a requirement serves as a guarantee to the bank that the borrower will repay the money quickly.
Your Business History
A consistent business history also can help convince a lender to approve a business loan. While all businesses will have different revenue levels at different periods, consistency is a must. This comes in handy when a bank determines the business loan amount, business loan fees, and repayment terms.
Here’s what you need to know:
- A business must operate consistently for about three years before the business owner(s) can apply for a business loan with favorable terms and interest rates.
- New businesses will have a higher interest rate with a shorter repayment period.
Your Business Type
Lenders know some types of businesses pose a higher level of risk than others. Even if a business owner has an excellent credit score and a huge down payment, that business owner may face higher interest rates than a business operating in a less risky market.
Here’s what you need to know:
- Before granting a business loan, loan originators will research the industry of the business and determine if it can do much better than its current potential in that industry in coming years with the loan disbursement.
- For the business’ market, it all boils down to risk and return. Lenders likely will prefer a business in the service sector over a business in the video rental market because DVD rental stores represent a dying business model.
What Are the Types of Business Loans and Their Interest Rates?
From big-name financial institutions to small banks to up-and-coming alternative lenders, you’ll find a variety of business loans with different interest rates. By familiarizing yourself with the various types of loans, you’ll better understand your options so you can decide which loan will serve your business best.
Outlined below is an overview of several types of loans you might consider.
This is the most common type of business financing and includes both long-term and short-term loans. Borrowers can repay long-term loans over the course of a few years or a decade while they must repay short-term loans in just a few months to a year. The interest rates on this type of loan usually depend on lender type:
- Traditional Banks: Term loans from this type of lender usually always come with lower interest rates. Expect these business loans to have a 4 percent to 13 percent APR.
- Online Lenders: These lenders make it easy for entrepreneurs to get early and fast funding. They can approve a loan for a new business in just a few months and accept lower credit scores. But, their term loans have a short repayment period and carry high costs. Expect business loan rates to come with a 7 percent to 99.7 percent APR.
U.S. Small Business Administration (SBA) Loans
SBA loans suit small businesses without a credit history or collateral to get a business loan approved. Backed by the government, these loans can command better interest rates.
They usually come in two types:
- 7(a) Loans: This type of SBA loan allows small business owners to apply up to $5 million with commercial banks, online lenders, and other such financial institutions. Expect them to have a 6.3 percent to 10 percent APR.
- Microloan Program: The SBA makes microloans available to small businesses through nonprofit organizations partly funded by the SBA. Excluding real estate purchases and debt refinancing, business owners may use these funds for any business purpose. Expect business microloans to have an APR between 8 percent and 13 percent.
This isn’t exactly a business loan, but a way to borrow against any outstanding invoices. With invoice financing, businesses can boost their short-term cash flow by selling unpaid invoices to factoring companies. Expect to pay an APR of 13 percent to 60 percent for this option.
Key considerations when choosing this option:
- With invoice financing, small business owners can get necessary funding quickly because the invoices serve as collateral for the cash advance from the factoring company.
- The loan interest may be very high, but, for many small businesses, invoice financing is an attractive option because it has a quick approval rate and usually helps them address a short-term need.
Business Lines of Credit
Business owners can use this loan option for a number of business purposes — from buying inventory to paying for business expenses. It works just like a credit card because there’s a maximum credit limit that ranges from $10,000 to $1 million. Expect interest rates for this option to range from an 8 percent to an 80 percent APR.
Key considerations when applying for a business line of credit:
- You’ll need a strong revenue stream as well as a healthy credit score to open a business line of credit.
- You can access funds from a business line of credit at any time without having to worry about recurring payments. You can use the money, as needed, pay it off, and then borrow against the line of credit extended to you by the bank.
Merchant Cash Advances
Merchant cash advances provide fast, lump-sum distributions. But, they come with the highest borrowing costs of all other financing options in the business lending industry. With a merchant cash advance, a lender advances money to a business with a cash reserve and, in return, the business owner must pay the lender a certain income from the business’ credit card sales on a daily basis. Expect merchant cash advance interest rates to run between 20 percent and 250 percent.
Key benefits of merchant cash advances:
- They are beneficial for borrowers who like to take risks and are less likely to qualify for other loan options and need cash urgently.
- Rather than using APRs like other financing options, merchant cash advances use factor rates so business owners know the exact cost of the loan. Knowing the total cost of borrowing the money can help business owners plan accordingly when choosing this option.
These loans allow businesses to purchase heavy machinery and other equipment at any stage. The equipment itself serves as collateral for the loan, which means there’s usually a lot of flexibility in the repayment terms. Expect APRs for this loan option to vary between 4 percent and 40 percent.
Key benefits of equipment financing:
- This loan option can help business owners manage small monthly payments if they can’t afford to pay for equipment out of pocket.
- The life span of this loan option usually lasts as long as the life expectancy of the equipment itself.
Business Credit Cards
Business credit cards provide revolving lines of credit, but they don’t have the same restrictions of term loans. They do, however, have collateral requirements, annual fees, and APRs. Expect business credit card APRs to fall in line with an average of 15.37 percent, depending on your business credit score and personal credit score.
Key considerations when applying for a business credit card:
- There’s no lengthy application process or any risk to personal assets.
- Business credit card borrowing is reported to the major business credit bureaus.
- You should only borrow 30 percent of your available balance from month to month because any more can unfavorably affect your business credit scores.
- Business credit cards can quickly boost business credit scores, if used judiciously.