Small business loans charge interest in a variety of ways, making it challenging to compare loans
Annual percentage rates give the most accurate picture of loan costs, including interest and fees
Alternative or bad credit business loans may charge flat fees like factor rates
The Truth in Lending Act enacted in 1968 protects people comparing consumer loans by requiring lenders to disclose fees up front. It also requires uniformity in showing interest rates as an annual percentage rate (APR), a rate that includes both interest and fees. But to date, the act doesn’t apply to commercial products.
The result? Business loan lenders charge interest in a number of ways, making it challenging to compare loan costs from different lenders. Business loans may assess borrowing costs as simple interest, an annual percentage rate or a flat fee.
Let’s dive into the specifics of how small business loan interest rates get applied.
How do business loan interest rates work?
Business loan interest rates are charged as a percentage of the loan amount. The interest is calculated on the principal, the amount you initially applied for that you haven’t repaid.
Because interest is calculated with each payment, you can shave money off the total interest by paying off the loan early. You can also save by making higher payments than expected applied toward the principal. This means the lender will calculate interest on a lower outstanding principal at your next payment.
Some lenders charge a prepayment penalty, a fee applied for paying off the loan early. Depending on the exact charge, it could offset any extra payments you’ve made.
What is a good interest rate on a business loan?
If you have excellent credit, the business loan interest rate you can expect will fall between 6 percent and 8 percent. But interest rates can depend on the type of lender you choose too.
Traditional banks tend to stay on the low end with current interest rates ranging from 5.5 percent to 10.5 percent. Online lenders can have a wider range from 6 percent to 30 percent, accepting businesses considered a higher risk than traditional lenders.
Here are the interest rates you can expect for different categories of business loans:
Types of business loan interest rates
Most small business owners expect to pay interest on the business loan they apply for. But they may not realize that business lenders can use different methods to charge interest rates.
Annual percentage rate (APR)
An annual percentage rate (APR) is the cost of the business loan’s interest and fees across the entire year, expressed as a percentage. The lender calculates the APR on the principal amount you borrowed on a daily basis, allowing the interest to compound between payments. If you apply extra toward the principal, the total amount will be lower, saving you on total interest.
APRs can be both fixed rate or variable rate with the interest rate changing according to the lending market. But since APRs show the interest rate over the year, a lower APR over a long term can result in higher total interest paid. You can use a business loan calculator to play with possible business loan interest rates and terms, seeing how different repayment terms affect the interest you pay.
Simple interest rate
A simple interest rate entails the lender applying a total percentage to the entire loan before you start making payments. The benefits of simple interest is that it doesn’t compound and you don’t have to worry about variable rates that could cost you more money. With simple interest, you clearly see the entire interest charge upfront on your loan agreement.
To calculate simple interest, use this formula: Principal loan amount x interest rate x loan term = interest.
An example of a simple interest charge may look like:
$10,000 x 0.05 x 3 years = $1,500 in interest
$10,000 + $1,500 = $11,500 in total borrowing costs
With simple interest, you may be on the hook for repaying the total interest amount even if you pay off the loan early. This may be a disadvantage compared to APR: If you repay an APR business loan off early, you save on interest costs. A simple interest rate also doesn’t reflect additional loan fees charged, so you can’t directly compare it to an APR.
Monthly or weekly rate
Some business lenders charge a percentage calculated on the outstanding principal each week or month, called a monthly or weekly rate. In other words, it’s the rate charged without considering the amount of time you’ll be repaying.
Stating just a monthly or weekly rate can make the loan’s total borrowing cost look much cheaper than other loans available. To make sure you’re getting a good deal, it’s best to compare the total interest paid to the total interest for another business loan.
How do flat fees work?
Business loans may go with a flat fee charged as a set dollar amount, a percentage of the entire loan or as a decimal applied to the entire loan. The fee is charged in place of interest, and it’s applied at the beginning of the loan rather than calculated per payment.
A flat fee makes it easy to see the full borrowing cost from the loan’s outset. But you may have to pay the entire fee no matter how early you pay off the loan. As a workaround, some lenders offer a prepayment discount for an incentive to pay off the loan early.
Types of small business loan flat fees
The most simplified version of a flat fee is a set dollar amount added to the loan, such as $500. But many business loans using flat fees use other methods to calculate the fee:
A factor rate uses a decimal to calculate a business loan’s borrowing cost, multiplying the loan by a rate like 1.1 or 1.5. Factor rates are usually seen with merchant cash advances or other business loans open to businesses with fair or poor credit.
Let’s say your business is borrowing $50,000 with a loan charging a 1.3 factor rate. To figure the cost of borrowing, you multiply the loan amount by the factor rate ($50,000 x 1.3 = $65,000). The total borrowing cost would be $65,000, and the total fee paid would be $15,000 ($65,000 – $50,000 = $15,000).
A discount rate refers to the fee charged for getting funding through invoice factoring. This type of small business loan provides an advance on unpaid client invoices after the small business sells the outstanding invoices to the factoring company. The discount rate is assessed as a percentage of total invoices.
The fee is often time-based, meaning the factoring company will charge the discount rate monthly or weekly. The faster your client pays, the more you’ll save on borrowing costs with this type of financing.
Unlike consumer loans that are required to show APRs, business loans aren’t as regulated in terms of interest rates and can charge interest in a number of ways. The most common types of interest rates are annual percentage rates (APRs), simple interest rates or factor rates.
APRs are the most ideal format because they include the interest cost plus loan fees, while simple interest and factor rates don’t roll loan fees into its figures. Looking at the overall interest cost plus additional fees can give you a solid idea of how different business loans compare to each other. Once you separate the differences between these rates, you can more easily compare the best small business loans available for you.
Frequently asked questions
Outside of interest rates, business loans may charge additional fees to help with administrative costs. Origination fees are common, paying the lender for processing the small business loan. You may also pay an appraisal fee for professionals to determine the value of collateral for secured loans. If you’re getting a business line of credit, you may also see a monthly or annual fee or a draw fee charged each time you withdraw funds.
Yes, business loans compound interest when lenders use an APR for charging interest. The APR is calculated on the outstanding balance daily, accruing until you make a payment. As you make payments, the balance you owe decreases, and the lender then calculates the daily APR on the lower balance. Over time, you end up paying less in interest due to the lower principal until the loan is paid off.
Many business loans set up monthly payments, but there are plenty of loans requiring weekly or even daily payments. These shorter schedules usually come into play with a short-term business loan, line of credit or merchant cash advance. Equipment loans will sometimes allow longer repayment periods like quarterly or annual payments. This allows for seasonal fluctuations in revenue, especially helpful for startups needing equipment to start driving revenue.
Many business loans are amortized, which is a schedule that shows how payments are divided between interest and principal. The principal is the initial amount of money borrowed that hasn’t been repaid yet. An amortized loan keeps each payment the same. But the schedule usually starts out applying more payment toward the interest and less toward principal, then switches so that more principal gets paid in future months or years.