When you’re trying to find a business loan, you’re trying to balance your risk with your reward. Naturally, many entrepreneurs value low interest rates because of this.
While a low interest rate shouldn’t be your only measure of a quality lender or loan type, it can certainly inform your decision when choosing a loan.
What is an interest rate, anyway?
You might have heard interest rate and APR used together, but it’s important to distinguish the two.
- Interest rate — This covers the cost of borrowing the loan principal, shown as a percentage. This won’t include all additional fees, only the percent of a loan that will be interest. Interest rates can be fixed or variable.
- Fixed — This type of interest rate won’t change over the life of the loan. This can be a benefit if you get a good rate when you take out the loan.
- Variable — This type of interest rate fluctuates based on market changes. A variable interest rate can rise and fall, which could be a benefit if you catch a variable interest rate as rates decline.
- APR — The APR is the annual percentage rate, including the interest rate and additional fees such as origination fees, closing costs, application fees, etc. This is a more holistic approach to looking at the cost of a loan, so dig into this when you start seeking one out.
How do lenders decide your interest rate?
So what determines your interest rate when you’re looking at financing options? We asked some experts to weigh in.
Jack Choros, Content Manager at CPI Inflation Calculator, opens the conversation with some financing facts everyone should know: “The success of any credit application usually relies on the five Cs of credit:
- Character — Will you pay on time?
- Capacity — Do you have the resources to pay off your credit?
- Capital — Is your business stable?
- Conditions — Can you agree to and meet conditions that lower the bank’s risk?
- Collateral — What can the bank take if you can’t pay?”
What this boils down to will depend on your lender. “Some basic criteria that affect interest rates are your personal and business credit score, financial strength, use of funds, and time in business,” says Jay Chang, Senior Vice President of Sales Acceleration at Lendio.
And traditional lenders sometimes have different criteria from online lenders. Some online lenders look at hundreds of data points to assess your loan application. Jeffrey Bumbales, Director of Strategic Marketing and Partnerships at Credibly, explains that no lender is going to be the same: “Each lender has its own proprietary scoring model. Your file will appear more or less risky (and thus, expensive) depending on how well you stack up against the model.”
What types of business loans will typically have higher interest rates?
Lenders consider several facets of your business when setting an interest rate. But there are some types of loans that, regardless of your flawless credit score and lengthy time in business, will generally have higher interest rates. What are they?
Merchant cash advances and invoice financing
“If a business opts for merchant cash advances or an invoice financing loan, interest rates will be high if measured annually,” explains Jared Weitz, CEO of United Capital Source. “Because these programs use ‘factor rates,’ which compute to one fee for the life of the financing, it’s not possible to measure these programs the same as we would a traditional business loan.”
Fixed rate loans
Jack Choros agrees that cash advances typically carry higher rates. However, he also mentions a couple other types of business loans: “Fixed loans typically are also financed at higher rates.” Remember what we said about fixed rates having the benefit of consistency? They can also have the drawback of a higher rate than a variable loan, because lenders can’t adjust interest for market changes.
Business credit cards
Choros continues, “Of course, business credit cards will be higher than all of those other credit facilities just because of the convenience it affords and the fact that credit cards are designed for paying off more immediate expenses.” A business credit card is a perfect example of a product with a high interest rate that isn't necessarily a bad thing. This lending option is intended for quick payoff, so it makes sense that there's a penalizing interest rate if you neglect it.
With this in mind, Bumbales asserts that your interest rate “completely depends on the file. Some equipment financing products only require a 400+ credit score as the transaction is collateralized by the machine. In general, obtaining the best pricing is less about the specific product and more about the specific file.” Having a strong application will do more for you than choosing a loan type based on rate estimations.
Which types of business loans typically will have lower interest rates?
Typically, any secured loan options will have lower interest rates. A lender is more likely to give you good terms when you have collateral. Bumbales agrees: “Products that are harder to qualify for, are collateralized, or generally less risky tend to have more favorable pricing.”
Of course SBA loans come with great rates and repayment terms; they’re backed by the Small Business Administration, which reduces lender risk. Chang notes that they have some of the lowest interest rates.
Naturally, SBA loans have many requirements. The SBA website mentions requirements including being a for-profit business, operating in the United States, having invested equity, and having no other lending options.
Traditional bank loans
Weitz also notes the low interest rates of SBA loans, but he mentions that traditional lenders also offer low rates: “In 2020 the annual interest rate for these types of loans is between 2 percent and 15 percent.”
Traditional bank loans can have a slow approval time and lots of paperwork, but the payoff for more work is low interest rates.
But similar to Bumbales’ advice on high-interest loan types, Weitz reminds readers, “The best thing to do is to shop around and make sure you are approaching lenders that meet your business size and financial requests.” Don’t choose solely based on loan type.
How do you decide on a good business loan?
For one thing, there’s a lot more to look at than an interest rate. Creating a plan of attack will help you shop for business loans with a clear goal in mind.
Evaluate why you need a loan
“Do your due diligence and vet out what you need the loan for and how quickly you can repay it,” advises Weitz. “This will direct you towards the better options for you. A low interest rate isn’t the only thing to look at when you are determining loan options, make sure you agree to any collateral requirements, duration of the loan, prepayment penalties and other fees that apply if you deviate from the loan guidelines.”
“My advice to entrepreneurs seeking a good business loan interest rate is to shop at more than one bank,” says Choros. “Just because a bank may already have a lot of your business, doesn’t mean they will give you the best rate on a new loan or credit product. Don’t take anything for granted. There’s always a bank out there willing to give you a better rate as long as you’re willing to do some shopping around.”
Determine the ROI
“Examine the opportunity and the ROI on the investment and compare it to the interest rates,” suggests Chang. “Many borrowers look solely at the interest rates, but forget to compare it with the potential ROI.”
So, what's a good interest rate on a business loan?
As with most things in life: it depends. According to our sources, you can find annual interest rates as low as 2 percent for traditional bank loans and small business loans, but rates for these lending options typically hover around 3 percent to 4 percent on the low end. Determining the ROI for your loan will help you find the best interest rate and terms for your needs; you may find that a loan with a high interest rate and short repayment term is better for your business.