One of the most important considerations when looking for a business loan is the interest rate. The rate will indeed affect the total cost of borrowing and can have a major impact on the cashflow and the profitability of the business. Business loan interest rates are determined by several factors such as the borrower’s creditworthiness, loan amount, term length, and broader economic conditions. By knowing this, business owners can make a proper decision and get favorable loan terms.
This article will discuss the key elements that determine the interest rate of business loans, offering great insights for entrepreneurs seeking the best financing options.
Understanding Business Loan Interest Rate
- Definition of Interest Rate and its role in Business Loan
The interest rate on a business loan is the percentage charged by lenders for borrowing money. It represents the cost of securing funds and is usually expressed as an annual percentage rate. Interest rates directly affect the total repayment amount, thus influencing a business’s cash flow and profitability.
- Types of Business Loan Interest Rate (Fixed vs variable)
Business loan interest rates can be broadly classified into two – Fixed and Variable interest rates.
As the name suggests, for loans with a fixed interest rate, the interest rate component is decided during the application phase of the loan, and the same remains unchanged throughout the loan tenure. Any macroeconomic event like rate cuts or rate increase by the central bank would have no impact on the cost of borrowing i.e. interest rate of the loan.
For loans with Variable interest rates, the interest rates are not fixated as a whole during the application phase. Rather the rate of interest is kept as a base rate plus a constant premium. Since the base rate keeps on changing with every rate cut or rate increase, the overall interest rate also changes.
- How Interest rates impact the total cost of borrowing
Cost of borrowing can be defined as the extra amount that the applicant ends up paying to the lender to secure a debt. Total cost of borrowing can have several components like interest rates, processing fees, stamp duties, fees and charges, etc.
Interest rates are the biggest and most impactful component of the total cost of borrowing and even slightest change in interest rates can have a major impact on the overall cost. The impact magnifies further in case of loans with longer repayment tenure.
Key Factor that Affect Business Loan Interest Rate
For an entrepreneur looking to secure a business loan, a major question may arise – What factors determine interest rates? Well, there are several factors which can play a crucial part, let’s discuss a few in detail!
- Credit Score
Credit score is one of the most crucial factors that affect the interest rate component for any loan. What a credit score does is essentially indicate the credit risk associated with lending to a particular borrower. There are various determinants of credit score like any past defaults on loan, delayed repayment history, number of loans and their value, credit utilization ratio, age of credit relationship, among many other factors.
An applicant with low or less than optimum credit score indicates higher risk, and to compensate for the risk, a higher interest rate is offered. Hence, it is absolutely critical for a borrower to ensure that they’re implementing practices that have a positive impact on their credit score.
- Business Credit History
A business’ credit history gives a peek into the firm’s past loan accounts, and its details like repayment history, defaults, delayed payments, etc. it is one the most important factors that the lender takes into consideration while assessing the loan application.
A positive business credit history can help entrepreneurs secure business loans with favourable terms like lower interest rates, less processing fees, etc. which decreases the total of cost of borrowing considerably, especially for loans with longer tenures
- Loan Amount & term
Loan amount and term has one of the biggest impacts on the interest rate on business loan in India. An application for a bigger amount of loan increases the risk factor for lenders, which essentially means lenders offering higher interest rates as in an event of default, the risk exposure would be higher due to a higher loan amount.
The same holds true for loans with longer term too, loans where the applicant is applying for a longer term than usually offered for loans of similar size indicates low repayment capacity, essentially increasing the risk exposure hence lenders offer higher interest rates in such cases too.
- Collateral
Higher risk translates to a higher interest rate. The lenders take up risks while lending money which is compensated in the form of interest rates. A lower risk is always desirable for the lenders, and they may look at various measures to mitigate the same. One such measure is backing the loan by a collateral.
A collateral is a form of asset which is used to back the loan. In case of default or non-repayment of loan, the lender has full right to liquidate the collateral to recover any outstanding dues.
What collateral does is essentially decreases the risk for the lenders as the loan amount can be recovered even in an event of default by the borrower. This has a positive impact on the interest rate for the borrower as they’re able to negotiate better loan terms and interest rates with the lender.
- Repayment History
Repayment history helps the lenders make an assessment of the risks involved with lending money to a borrower based on their borrowing and repayment patterns. It allows the lenders to identify any unhealthy borrowing patterns which can have an impact on the current loan application.
If a borrower’s repayment history indicates delayed repayments, repayments extending beyond loan tenures, and irregular and unreliable repayment patterns, then the lenders can either reject the application, or offer a substantially higher interest rate loan to cover for the risks.
In either case, repayment history has a major impact on the interest rates. And a strong repayment history can be leveraged to secure a business loan with low interest rates.
- Economic Conditions
Economic conditions have a major impact on the lending market. Reason being, macroeconomic conditions dictates the bank rate and also credit taking capacity in the economy. This has a snowball effect on the interest rates offered by the lending institutions.
For example – In a rapidly growing economy, the credit penetration is high which leads to higher competition, and lower interest rates and vice versa.
Impact of Interest Rates on Business Operations
- High Interest rates affecting Monthly Payments and Cashflow
Interest rates are directly proportional to the overall cost of borrowing. A loan with higher rate of interest will attract high cost of borrowing i.e. the borrower will end up paying a higher amount in addition to the principal, and vice versa.
If a borrower secures a loan with high interest component, this will increase the overall amount that is to be paid to the lender, essentially increasing the monthly payments against the loan.
High monthly payments will have a negative impact on the business cashflow and operational efficiency, as a relatively bigger part of the revenue will go towards the loan payment, decreasing the amount left to be utilized for business operations and expansion activities.
- Long Term Cost Implications on Business profitability
High interest rates essentially result in a high cost of borrowing and a higher monthly payment. This results in a bigger chunk of revenues going towards loan repayment, and less capital left to utilize efficiently towards the business operations, measures to increase profitability, or even expansionary activities.
Hence, high interest rates have a direct relation and cost implication on business profitability.
Strategies for Securing Better Business Loan Interest Rates
- Improve Credit Score
The first and foremost step to secure better business loan interest rates would be to improve credit score. Assessing an applicant’s credit score is one of the primary checks that a lender performs to assess an application. An applicant with poor credit score brings higher risk to the lender’s loan book, hence they prefer lending to ones with a good credit score.
There are certain amendments that an applicant can make to improve credit score like, paying off any past loan liabilities, keeping credit utilization low (it is advised to keep it below 30%), having a healthy credit mix, ensuring on time repayments, etc.
- Provide Collateral
High risk associated with lending is the biggest roadblock in securing favourable loan terms and lower business loan interest rates. Lenders offer high interest rates to mitigate their lending risk. Hence, to secure business loans with lower interest rates, the applicant can provide a collateral. This will add a layer of protection for the lenders and essentially decrease their overall risk, hence enabling them to offer lower interest rates.
However, the applicant must be aware that by offering a collateral, the borrower gives the lender full rights to liquidate the collateral to recover any outstanding dues in an event of default.
- Compare Terms offered by different Lenders
One of the major deciding factors that make a loan suitable for a borrower is the interest rate and the loan terms offered. If an entrepreneur is planning to secure a debt funding, then it becomes essential to compare available loans from different lenders to be able to make a decision more suited to the borrower strategy and cost bearing capacity for capital injection in the form of a loan.
Borrowers can take a quote from multiple lenders to assess the most suitable loan.
However the borrower should ensure that they’re not making any hard credit enquiries, as multiple credit enquiries can have a negative impact on the credit score. Just a soft query with a high level check on interest rates and loan terms should do the job.
- Consider Government Supported Loans
Governments often run schemes to support businesses in a particular sector or at a particular maturity stage and size. If your business qualifies for securing funding under special government run schemes to support businesses like priority lending for a particular sector, MSME loans, etc. then it can greatly benefit your business as usually these schemes loans at a lower interest rate, and relaxed requirements to cover maximum businesses. This can be leveraged to secure cheaper loans to boost profitability.
Pros and Cons of High vs Low Business Loan Interest Rates
Low Interest Rates
- Pros: Lower monthly repayments, less financial strain.
Low interest rates decrease the cost of borrowing, hence essentially spreading the lower total payable amount throughout the loan tenure. Hence, loans with lower interest rates have lower monthly repayment, relieving financial strain from the borrower
- Cons: Potentially stricter eligibility criteria or more stringent loan conditions
Securing a Low interest rate loan is not easy, securing the same attracts stringent eligibility criteria like higher credit score requirement, stronger business financials, collateral requirements, among many other factors makes low interest rate business loan difficult to secure.
High Interest Rates
- Pros: Easier approval process, quicker access to funds
It is comparatively easier to secure approvals for loans with a higher interest rate component, although higher interest rates loans are really a disadvantage, however these can be considered a boon for businesses in immediate need of capital injection in the form of loans
- Cons: Higher overall borrowing costs, greater impact on cash flow
High interest rates increase the cost of borrowing, essentially an entrepreneur ends up paying a substantially higher amount compared to the principal amount. This increases the fixed repayment which will have a negative impact on the cashflow as the business end up paying a higher amount in loan repayment
Conclusion
The interest rates on business loans are determined by several factors, with two major types: fixed and variable. Fixed interest rates are constant over the period of the loan, while variable interest rates change with a change in the base rate. Interest rates have a very significant impact on the total cost of borrowing, especially for longer-term loans.
The key factors to consider in determining loan interest rates include the borrower’s credit score, business credit history, loan amount and term, collateral, repayment history, and broader economic conditions. The better the credit score and business credit history, the better the chances of gaining a lower rate. An unfavorable repayment history or even a higher loan risk leads to higher rates. Collateral helps reduce perceived risk.
These include paying off debts and maintaining a good credit score to have good rates, offering collateral to the lender, comparing terms from different lenders, and exploring government-backed loans.
Low interest rates provide lower monthly repayments but may have more stringent eligibility criteria. High rates are easier to obtain but comes ata cost of higher overall borrowing costs. Business owners should carefully assess their situation to balance the pros and cons of different interest rates and loan terms.
