For bank loans with long loan terms, you might pay a 10 percent interest rate. At the same time, an online lender might charge you triple that on a short-term loan if you have a poor credit score. Then there's SBA loans, which usually come with relatively low interest rates; but you'll first need to prove that you haven't been able to procure traditional funding. At a high-level, determining the rate of a small business loan is deceptively simple. Business loan lenders choose a benchmark interest rate and add a markup to determine their prime rate. This prime rate is what they charge borrowers with an ideal risk profile. When providing loans to riskier borrowers, the business lender marks up the prime rate to compensate for the added risk. In a nutshell, this is how most business lenders come up with their interest rates. However, there’s a bit more nuance to it that’s important to know as a small business owner pursuing additional financing options. In this blog post, we’ll explain in further detail how lenders determine their interest rates and why it matters to business owners when selecting an alternative financing lender. After reading this post, you should have a clear understanding on how financial institutions determine their business loan rates, so you can select a loan product that you can comfortably afford.
How Do Business Financing Lenders Determine Loan Rates?To understand how lenders determine their small business loan rates, it’s helpful to review the relationship between risk and return and supply and demand. In the next two sections, we’ll explain these concepts and how they relate to typical rates for business loans.
Risk vs. ReturnBefore a business loan lender sets up shop, they establish criteria for the investments (i.e., business loans) that they’re willing to make. One of the business loan lender’s most important investment criteria is the risk and return profile. A lender’s risk and return profile determines how much risk they're willing to take in exchange for a certain level of expected return. Since more risk must be justified by a higher potential return, riskier business loans come with higher interest rates. What’s considered a “riskier” loan depends on many factors. Borrowers with few assets or invested capital make an installment loan riskier for the lender. An environment in which interest rates are rising makes certain loans riskier. Factors specific to your industry or business may make a loan riskier as well.
Supply and DemandWhen you take out a small business loan, your interest rate is the price you pay for borrowing money. Like any price, interest rates are subject to the forces of supply and demand. With interest rates, the supply is money, and the demand comes from both borrowers and the investors funding lenders. That means anything that restricts the supply of, or increases the demand for, money will increase interest rates. For example, when the economy is growing, typically there’s a greater demand for credit. Entrepreneurs want funds to capitalize on the opportunities presented by a healthy economy. Holding all else equal, this demand will increase interest rates. Similarly, if interest rates go up for government debt, that gives business loan lenders and investors a more attractive alternative. To compel lenders and investors to make business loans, then, interest rates must go up for business loans too. Finally, the federal government can also cause interest rates to rise through open market operations.
Lender-specific Forces that Affect Business Loan Interest RatesAs an individual, you can’t affect market and regulatory forces; even traditional lenders can’t control these forces. However, what you can take advantage of to get the best rate as a borrower are lender-specific forces Lender-specific forces refer to the following costs:
- Origination fees
- Funding costs
- Closing costs
- Servicing fees