Interest rates for business loans can be a confusing topic, as there are multiple factors that affect how much you will pay, as well as different ways of calculating interest. It’s important to have a thorough understanding of interest rates when you seek a loan so that you can accurately compare offers and choose the loan with terms that best suit your business.
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What types of interest rates do business loans have? How are they calculated?
Interest rates vary depending on the terms of the loan and are affected by current market interest rates as well as other factors related to your business’s industry, credit score, and financial qualifications, the type of loan, and the type of lender.
The prime rate—the interest rate that banks offer to the most creditworthy borrowers—also affects interest rates. Lenders may set interest rates as a percentage of the prime rate—for example, the prime rate plus 5% (this is commonly called the spread). If the current prime rate is 3.25 percent, the loan’s interest rate will be 8.25%.
It’s important to understand the difference between an interest rate and an annual percentage rate (APR). An interest rate is a percentage of the amount of money borrowed that you must pay to the lender. It does not include other costs such as fees. Many loans include one-time fees such as origination fees, which can be a flat fee or a percentage of the loan. The APR is the total cost of the loan, including interest and fees. The APR is also expressed as a percentage of the loan amount. When you’re comparing loans, you will want to compare the APR, as fees can make a big difference to the total cost.
Example:
| Principal | $100,000 |
| Term | 5 years |
| Interest Rate | 3% |
| Fees | $5,000 |
| Monthly Payment | $1,796.87 |
| Total Loan Cost | $12,812.14 |
| APR | 5.094% |
Interest rates can be calculated in multiple ways.
Simple Interest
Simple interest is calculated based on the amount of the loan, interest rate, and length of the loan. To calculate a simple interest rate, you simply need to multiply the principal amount by the interest rate and the duration of the loan.
Example:
- You receive a loan for $20,000 with an interest rate of 6%. The term of the loan is one year. $20,000 x 0.06 x 1 = $1,200, so this is the amount of interest you will pay for the year.
Compound Interest
Compound interest is an interest rate that is charged on the principal plus the accumulated interest. This means that interest is charged on the added amount of interest. Interest can be compounded daily, weekly, monthly, or annually. The cost increases with the frequency of compounding. It’s important to understand if your loan charges compound interest as this can increase the expense of the loan.
Example:
- You receive a loan for $30,000 with compound interest. Interest compounds annually. Your interest rate is 5%. For the first year, your interest rate would be calculated as $30,000 x 0.05 = $1,500. For the second year, your interest rate would be calculated based on the principal plus the added interest: ($30,000 + $1,500) x .05 = $1,550. This would continue each time the loan is compounded.
Factor Rate
A factor rate is an alternative to traditional interest rates that is used for some short-term loans, merchant cash advances, or invoice financing. Factor rates are commonly expressed as a multiple rather than a percentage (e.g., 1.15 vs. 15%). Essentially, the cost of a loan is a fixed amount equal to the loan amount multiplied by the factor rate.
Keep in mind that factor rates are calculated before the loan is issued, so the full cost of the loan is set as a fixed fee, which is different than with amortizing loans. With amortizing loans, as you pay down the principal, your interest payments also go down. This is not the case with factor rates.
When comparing loans, be aware that a factor rate is not the same as an interest rate. If your loan charges a factor rate, the APR can be very different from a loan with a traditional interest rate, especially for loans with very short terms. Make sure you understand the true APR before choosing a loan.
| Factor rate loan | Interest rate loan | |
|---|---|---|
| Term | 1 year | 1 year |
| Loan Amount | $10,000 | $10,000 |
| Rate | 1.2x | 20% |
| Financing Cost | $2,000 | $1,116.14 |
| Total Loan Cost | $12,000 | $11,116.14 |
| APR | 35% | 20% |
Fixed vs. Variable Interest Rates
Business loan interest rates can be either fixed or variable. Fixed interest rates remain the same over the life of the loan, which means that you will always know exactly how much you owe for each payment since the amount of interest charged will remain the same. This can make it easier to plan your budget. Fixed interest rates are a common feature of business term loans.
In contrast, variable interest rates can increase and decrease over time based on market conditions. They are tied to a base index, which is typically the prime rate—the interest rate for banks’ most creditworthy borrowers. Variable interest rates are calculated as a percentage amount above the prime index.
A loan with a variable interest rate could start out with a lower interest rate than a fixed interest rate loan but end up increasing and becoming more expensive as the market changes. However, if market indexes remain similar over the life of the loan, you would end up paying less in interest.
It can be harder to budget for loans with variable interest because payments can change depending on the current interest rate. However, for shorter-term loans during which the variable rate probably will not change dramatically, you may be able to save money with a lower variable rate. Most business lines of credit and credit cards have variable interest rates, and other loans may offer this type of interest as well.
What types of fees do business loans have?
When you choose a loan, it’s important to consider the fees you may need to pay on top of the interest rate. Some loans may have a number of additional fees that could significantly increase the cost of your loan. Make sure that you’re taking a look at the APR when evaluating loans from different lenders, as this will allow you to make an apples-to-apples comparison on total loan costs.
The types of fees charged can vary and may be called different names by different lenders. Some common fees include:
- Application fee. Some lenders will ask for a fee upfront when you apply for a loan.
- Origination fee. Origination fees pay for loan processing and are usually charged upfront. In some cases, the origination fee will be charged as a flat fee, while in other cases it will be charged as a percentage of the loan amount.
- Service or administrative fees. Lenders may charge service fees or administrative fees. These fees could be charged with each loan payment, annually, or as a one-time fee.
- Packaging fee. Lenders or loan brokers may charge packaging fees for gathering and preparing your documents. SBA loan providers are allowed to charge reasonable packaging fees.
- SBA loan fees. SBA 7(a) loans charge a guarantee fee, typically between 2% and 3.75%. CDC/504 loans have annual servicing fees.
- Closing fee. Commercial real estate loans often have closing fees covering costs such as appraisal, survey, and legal fees.
- Referral fee. If you obtain a loan through an online lending platform or broker that refers you to a lender, you may be charged a referral fee.
There are also several penalties you could incur, which are not included in the loan’s APR.
- Prepayment penalties. Many loans discourage early repayment by charging borrowers a penalty if they pay the loan off early. However, some lenders will allow you to pay your loan off early without penalty.
- Late payment penalties. If loan payments are made after the due date, lenders generally will charge either a flat rate fee or a percentage of the payment amount.
What are the average interest rates for business loans?
AdvisorSmith found the average interest rate for small business loans was 2.77% at the beginning of 2021. Loan interest rates can vary widely depending on the lender, type of loan, and type of business. For loans from banks to small businesses, the average ranges from 1.7% to 5.4%, with alternative lenders typically offering higher rates ranging from 4.8% to 30.1%.
Interest Rates by Type of Lender
The type of lender has a major effect on interest rates. Traditional lenders such as banks and credit unions generally offer the lowest rates, but they have stricter qualifications for borrowers and a lengthier application process, meaning that it may take longer to receive funds.
Businesses that need to access funds quickly or don’t fit the requirements of bank loans may benefit from a loan from an online lender. Online lenders are more likely to lend to startups, businesses with lower credit scores, and businesses with lower revenue. In addition, they typically offer a streamlined, online application process that allows them to approve loans and disburse funds quickly.
| Type of Lender | Average Interest Rates |
|---|---|
| Banks or Credit Unions | 1.7% to 5.4% |
| Alternative or Online Lenders | 4.8% to 30.1% |
Interest Rates by Lender
Depending on the lender and the product, you will see varying interest rates. While we’ve gathered information on interest rates from a variety of lenders, these rates are just an estimated range, and it’s to your advantage to look into the specific lender and product to see what your exact rate would be.
| Lender Name | Interest Rates on Small Business Loans |
|---|---|
| Bluevine | 4.8% and up |
| Dealstruck | 9.99% to 21.99% |
| Credibility Capital | 6.99% and up |
| Credibly | 9.99% and up |
| Fundbox | 4.66% and up |
| Funding Circle | 11.29% to 30.12% |
| LendingClub | 4.99% to 24.9% |
| Lendio | 6% and up |
| OnDeck | 11.89% and up |
| SmartBiz | 4.75% to 24.99% |
Interest Rates by Loan Type
Different types of loans will have varying interest rates, with less risky, longer-term loans typically offering lower rates. We’ve gathered an estimated range of rates below.
| Loan Type | Interest Rate |
|---|---|
| SBA Loan | 3% to 9.75% |
| Short-Term Loan | 6% to 70% |
| Medium-Term Loan | 6% to 40% |
| Long-Term Loan | 3.5% to 30% |
| Business Line of Credit | 3.75% to 30% |
| Equipment Financing | 4% to 30% |
| Microloans | 8% to 20% |
| Commercial Real Estate Loans | 3% to 18% |
What factors affect business loan interest rates?
Interest rates are largely decided based on how much risk the loan presents to the lender. Businesses that are financially strong are considered to be lower risk to lenders because they are likely to repay the loan, while newer, less established businesses and those with a shakier financial history are higher risk and therefore will receive higher interest rates. Some of the factors that determine interest rates include:
Type of Lender
Banks, credit unions, and SBA loans typically offer lower interest rates than online lenders. However, they often have more stringent requirements and a lengthier application process. Online lenders are more likely to lend to businesses with lower credit scores, limited time in business, or lower revenue. They are also able to approve loans and disburse funds more quickly.
Type of Loan
Interest rates vary widely for different types of loans. Installment loans with longer terms typically have low interest rates, while more specialized loan products such as invoice financing or merchant cash advances can have very high interest rates.
Credit Score
Lenders will look at both your business and personal credit scores. Banks typically require high credit scores (often 680 or greater), while online lenders may work with those with lower credit scores.
Length of Time in Business
More established businesses are considered lower risk, so you are likely to get better interest rates if you’ve been in business for a longer period of time.
Financial Condition
Lenders will evaluate your business’s financial information, including revenue and any outstanding debts. Businesses with strong revenue and cash flow will likely receive better interest rates since they have a strong ability to repay the loan. The size of the loan compared to the borrower’s resources also has an effect. A smaller loan is easier to qualify for.
Relationship With Lender
Banks, credit unions, and online lenders all may offer special low interest rates to businesses they have an established relationship with. If you have a business bank account or have taken other loans from a particular lender and remained on time with your payments, you may be able to receive better interest rates from that provider.
Collateral
Loans secured with valuable assets typically have lower interest rates because the lender has the option to repossess the collateral if the borrower defaults on the loan, which reduces the lender’s risk.
Down Payment
When you are borrowing tangible property such as equipment or real estate, a down payment is generally required. If you are able to pay a larger down payment, you will likely receive a better interest rate.
Business Plan
Your business plan and goals for the loan can affect loan applications. Lenders want to see that you have a good plan for repaying the loan and a detailed business plan can help them see that you are a worthwhile risk. This is especially crucial for startups and newer businesses.
Final Word
Business loan interest rates can vary widely depending on the type of loan, type of lender, your business’s qualifications, and other factors. Because your loan’s interest rate and associated fees can greatly change the cost of the loan over time, it’s crucial that you understand how interest rates work in order to find the right loan for your company. If you carefully evaluate and compare rates from several different providers, you can find the loan that best meets your company’s needs.
