Business loan interest rates explained
- Red Not all costs associated with borrowing money are part of the interest rate
- Amber Interest you pay on borrowing for the business is a deductible expense
- Green Business loan rates may cost less than the revenue the business can generate using those extra funds
Small business owners face paying a higher interest rate on loans. Discover what contributes to the interest rate, the impact of APR on the overall cost of borrowing and why a start-up is likely to pay more.
What are interest rates?
Interest rates are the main (but not the only) cost in borrowing money. When you borrow money from a lender, you will be expected to pay back the amount borrowed (called the principal) and an extra amount, the interest.
Note that not all costs associated with borrowing money are part of the interest rate. Other costs include arrangement fees, set-up fees, early-repayment fees and insurance premiums.
Why would a business want to incur interest rate charges?
Borrowing funds can help a business. It could be used for buying raw materials or new stock, to purchase a shop or factory, hire new staff, purchase equipment or simply smooth out irregularities in cash flow.
Business loan rates may cost less than the revenue the business can generate using those extra funds. Whether the loan results in increased revenue or not, the loan must be repaid according to the loan terms, including interest. Therefore, determining the total cost of borrowing, including current business loan interest rates, is crucial.
Another reason to understand the interest rate you are being charged is that the amount of interest you pay on borrowing for the business is a deductible expense from your final profit or loss figure when your tax bill is calculated.
Business loan interest rates can vary substantially, based on your business or personal credit history, length of time trading, and business financials. The best business loan rates will be offered to companies that are established, have good financials and a good history of repayment.
How do interest rates work?
An interest rate is expressed as a percentage of the principal that must be paid to borrow the money for one year. If you borrow £1,000 at an interest rate of ten per cent per annum (‘per annum’ means ‘per year’), the total amount to be repaid at the end of that year is £1,100 (£1,000 principal + £100 interest). But how is the interest rate you’ll be charged determined?
The Bank of England base rate, also called the ‘bank rate’, is the interest rate the Bank of England charges to large commercial borrowers. Those borrowers, in turn, loan the money on, charging something above the bank rate so that they can make a profit.
If lenders are paying the bank rate for the money they are lending out, why do they charge more? And why do the amounts charged vary? Why are there high interest rate business loans and low interest rate business loans? It all comes down to risk.
A lender must consider not just what it paid for the money it is loaning out (and if it is a smaller lender, it may have had to pay more than the bank rate to borrow the money it is loaning out), but also how likely it is that a borrower will default on the loan. A borrower may be declined if they have a bad credit history, with previous defaults or a spotty payment history because the risk of default is judged too high. A small start-up business that has only been trading for a short time, may be offered a loan but at a higher interest rate than a larger, more-established business.
To help estimate the risk, the lender is likely to check your credit score with a credit reporting agency.
What are the costs of interest rates?
An interest rate is expressed as ‘X per cent per annum’. That is the basic interest rate. However, in addition to the interest rate, you may be required to pay other fees, such as a set-up fee. A fee, even though you may need to pay it up-front, effectively increases the cost of borrowing. If you borrow £1,000 at ten per cent per annum and pay a £50 set-up fee at the start of the loan, the total cost of borrowing at the end of the year is:
£1,000 (principal) + £100 (interest) + £50 (pound set-up fee) =£1,150
That extra £50 set-up fee is the equivalent of paying an extra five percentage points on a year-long loan. Your total finance cost was £150. That represents an ‘annual percentage rate’ (APR) of 15 per cent. The APR is the amount, including interest, fees and any other costs of borrowing. It’s therefore important to look at APR when considering finance, not just interest rates.
Consider two small business loan rates. One lender may be offering a £10,000 loan with a rate of 12 per cent per annum with no additional fees. Another lender may offer the £10,000 loan with a rate of ten per cent per annum with a £300 set-up fee. The APR on the first loan is 12 per cent; the APR on the second loan is 13 per cent, even though the interest per annum is lower on the second loan.
There are many different types of lenders, including banks, building societies, credit unions and specialist lenders. Be sure to consider the options offered by each to determine what is best for your business.
What type of security do I need for a good interest rate?
If you have property, whether it is a factory, home or vehicle, you may be able to negotiate a better interest rate with your lender by offering that property as security on the loan. However, in the event of a default, the lender may seize the security and you will lose that property.
If you are purchasing property, a vehicle or machinery, the asset itself may act as security for the loan. Asset finance, vehicle finance and commercial property finance are examples of this type of finance.