The good news is, the major factors lenders use to determine interest rates for small business owners seeking funding aren’t that complicated. Anyone with a few minutes and the will to do so can gain a strong grasp of these general concepts.
In this blog post, we’re going to first explain what business loan interest rates are. Then, we’ll explain how banks and alternative lenders determine their interest rates. We’ll wrap up by outlining how you can determine how interest rates will affect your overall loan cost.
What is a Business Loan Interest Rate?
You can think of interest rates as the price you pay to borrow money. Interest rates are usually expressed as an annual percentage and charged based on the amount of your loan. So if you obtain a $100 loan with a one-year term and a 10 percent interest rate, you’ll pay $10 in interest.
Note that, generally, you’ll also pay fees on a loan, which increases the price you pay to borrow money. This is why annual percentage rates
(APRs) are different from interest rates.
How Banks and Alternative Lenders Determine Rates
Interest rates are composed of the lender’s
cost of funds, operating costs, the risk premium, and a profit margin. While all loans share these cost components, their impact on interest rates differs based on:
- The creditworthiness of the borrower
- The type of lender
- The type of loan
- The economic and regulatory environment.
In the section below, we’ll explain each component’s impact on how banks and alternative lenders set their average interest rates.
The lender’s cost of funds
Every business incurs costs to provide their products and services. Lenders are no different; they have to raise money to lend to borrowers, which comes with a cost.
Banks typically raise part of the money they loan from customer deposits. To raise customer deposits, banks must advertise, market, and sell to prospects. Plus, they also need to serve their existing customers. All of that comes with a cost that’s built into your interest rate.
Unlike banks, alternative lenders typically rely on investors to raise funds. Since these investors aren’t giving funds away for free, alternative lenders also incur costs for this money.
Many other factors can affect a lender’s cost of funds: the health of the economy, government regulation, Federal Reserve rate changes
, and more.
The lender’s operating costs
Just like there’s a cost to online lenders for raising funds, there’s a cost of lending funds. This includes everything from loan officers’ wages and office rent to marketing expenses and administrative costs.
This is part of the reason you’ll see a variety of interest rates from alternative lenders and banks on similar loan products. Less cost-efficient lenders need to charge higher interest rates to offset their high costs.
A risk premium
The risk premium is added to an interest rate to compensate the lender for the risk of default. Assuming all else is equal, the riskier the loan request, the higher the risk premium, and vice versa.
The risk level of a loan request largely depends on the borrower, the type of loan, and the value of the collateral.
Statistically, borrowers with poor credit histories tend to default more often than those with good credit histories. Therefore, the risk premium on a loan made to borrowers with poor credit scores will be higher.
Fundamentally, banks and alternative lenders evaluate default risk the same way. However, banks and alternative lenders offer very different risk tolerances.
Therefore, since banks tend to make less risky loans, their risk premiums—and as a result their interest rates—are lower than those of alternative lenders. At the same time, to mitigate risk, banks have much more stringent eligibility requirements than alternative lenders.
The lender’s profit margin
Profit margin is the percentage over the cost of a loan that a lender needs to charge to earn an adequate return. Even among just banks, profit margins can range widely, from 5 to 45 percent according to Investopedia.
Generally speaking, the higher the volume of loan an alternative lender or bank originates, the smaller profit margin they can tolerate.
How to Determine How Interest Rates Affect Your Loan Cost
The formula for calculating your total loan cost is fairly complicated. Fortunately, you can use an amortization calculator and plug in different interest rates to see how your loan cost changes.
If you want to do it the hard way, you’ll first need to calculate your monthly payment. Then, you’ll need to multiply that monthly payment by the number of months in your loan term to get your total loan cost.
From your total loan cost, you can subtract the loan principal amount from the total loan cost. The remaining number will be your total interest cost, which is the best representation of how your interest rate affects your loan cost.
In the next section, you can see how all that looks, expressed with formulas:
Loan Cost Calculations
First you calculate the monthly payment, using this formula:
The letter “i” represents the monthly interest rate and “n” represents the loan’s total number of monthly payments.
Once you have your monthly payment, you can get your total loan cost by plugging your monthly payment and number of months into this equation:
Total Loan Cost = Monthly Payment x Number of Months
Then, you can figure out your total interest cost using this equation:
Total Interest Cost = Total Loan Cost - Loan Principal
A Few Reminders on Interest Rates
One thing borrowers often forget is that the total cost of interest and the rate of interest on your loan are very different. A loan may have a relatively high interest rate, but if it’s a short-term loan, the total interest cost may be relatively low.
Also, it’s important to remember that small business loan interest rates aren’t the only cost of borrowing. Depending on the small business loan and lender, you may have a variety of non-interest costs and fees
. These fees (such as origination and closing fees) often add up to a significant portion of your cost.
For more information on subjects related to interest rates, read these posts: