The interest rate on a small business loan is a percentage of the loan that is paid by the borrower to the lender with each payment and is how the lender makes their money. The rate is generated based on a combination of market conditions for lenders including borrower demand, the Federal Reserve federal funds rate (view the current one here), and the economic environment.
Once the base rate is set, lenders will evaluate a borrower’s creditworthiness (the measure of their reliability to repay the debt) combined with the assets they can offer as collateral to determine an interest rate. But many factors go into determining the rate. Here are some additional factors that may be considered:
- Business credit score
- Company finances
- Collateral to offer
- Deposit amount
- Character and reputation
- Industry and market conditions
- Existing debts
Anything that could cause a disruption or an increase in cash flow will lower or raise the borrower’s creditworthiness. In turn, this can decrease or increase the interest rate they’re offered on their business loan. If the borrower is in a risky market or has poor financials, using assets like equipment or stocks can offset the risk, and so can a larger cash deposit on the loan. If the risk is offset, the interest rate can go down. If the borrower remains high-risk, the interest rate will likely remain high.
Some business loan interest rates can have set maximums like SBA loans where the Small Business Administration sets rates based on the amount borrowed. The SBA publishes the caps here. For other types of business loans, the individual lenders (including both traditional banks and alternative lenders) set interest rates.
Traditional Banks vs. Alternative Lenders
Traditional, large banks generally offer lower interest rates than online and alternative lenders because they typically issue larger loans, require more documentation, and take longer to approve. Their loans also tend to have longer repayment terms, which can increase the total cost of borrowing over time, even at lower rates. By contrast, alternative and online lenders usually provide faster approvals and shorter loan repayment terms, but sometimes higher interest rates as well.
Note: The longer you owe the debt, the longer it stays on your business credit score, which can impact future loan applications. The borrower may also be charged penalties if they make curtailments (early or larger payments) on their financing, depending on the agreement.
Compared to traditional banks, alternative and online lenders typically have quicker turnaround times and shorter payback periods, allowing borrowers to clear the debt faster. Regardless of using a traditional bank or an alternative lender, each one has the ability to offer a unique interest rate based on your company’s situation.
What Causes Business Loan Interest Rates to Increase
Being less creditworthy and in a high-risk industry are the main causes of higher interest rates on business loans for individual borrowers. Industries that are more likely to go out of business or have cash flow gaps, like seasonal gift shops in beach towns, may likely get a higher interest rate because there’s more risk that the borrower will default.
Companies that have had a rough year or whose financials are not stable will be a higher risk for the lender, so they’ll likely get a higher interest rate on their business loans than companies with stable finances. The same goes for companies without consistent cash flow in their business bank accounts, or those that have outstanding business debts including credit card debt and balances due on a business line of credit. The more debts you owe and the weaker your cash flow, the more it will appear as if you are unlikely to make payments.
Your reputation as a business owner, your company’s brand, and your preparedness when applying will also play roles in the financing you’re offered. When applying for the business loan, you’ll likely need to submit a business plan that shows how you’ll use the funds, your current finances, and information about the team that manages the company.
If the underwriter does not feel confident in your business plan, ability to mitigate risk, or ability to drive financial results, they may offset the lender’s risk by increasing the interest rate. This is why a business plan for a business loan is important to get right.
There are plenty of reasons the interest rate on a business loan may be higher for a given business owner. However, there are also multiple ways to get it reduced.
Ways to Get a Lower Interest Rate on a Business Loan
Making your company appear more creditworthy or reducing the potential risk of defaulting can get you a better interest rate on a business loan. It’s a matter of building the lender’s confidence. Start by making yourself more creditworthy.
- Reduce your total debts owed before applying by paying off business credit cards and any equipment or vehicles that you financed. Having a lower debt to credit ratio will go far with the lender as it shows you know how to manage debts.
- Eliminate unnecessary expenses like extra snacks and drinks in the breakroom, trinkets and branded materials that sit in closets, and tradeshows or events that never bring in business but which you attend out of habit. Taking these steps can free up cash flow, showing the lender that you can make payments.
- Share how the financing will be used to grow both profit and revenue, and how much cash will remain available in good and bad market conditions. Now the lender will see you’ve prepared for all situations with the intent to make payments.
- Include any letters of intent where clients will be signing on once you can expand operations or increase production, and accounts receivable that are coming due.
Anything you can do to show fiscal responsibility and that there will be enough cash to make payments helps increase your creditworthiness. Once this is done, look at terms you can negotiate and what you can offer above what is being requested.
- Larger deposits show you are invested in your company and feel confident it will succeed, while reducing the risk to the lender as they have more of a safety net.
- Offering a personal guarantee is another way to show you have faith you can make the payments, as defaulting will allow the lender to seize specific personal assets.
- If you plan to expand and grow your business, or will need more financing in the future, make sure to share this information. The long-term relationship with multiple loans means more money for the lender, and that could get you a better interest rate on your business loan.
- Consider leveraging additional collateral. So long as you make payments, you won’t need to provide it to the lender directly, but having access to high-value collateral could encourage a lender to provide you with a better rate. If they have assets that retain or increase in value, and that are easy to liquidate, they have a lower risk if you don’t make payments.
The interest rate on a business loan is set by market conditions and the Federal Reserve, and can be impacted by your company’s financial standing and the industry you’re in. The more creditworthy you can make yourself, or the more you can offset the lender’s risk, the better chance you have at getting a lower interest rate on a business loan.
If you don’t want to have to spend time searching for a better interest rate, use a business loan marketplace like us. We help business owners find trusted financing providers that cater to your needs. Click here to fill out the form and get matched with your top recommended financing solutions.
SmallBusinessLoans does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
