How Do Business Loan Rates Work? Our Complete Guide
So, how do business lenders usually come up with their rates?
At a high-level, determining rates is deceptively simple. 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 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 business owner pursuing 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 a financing lender. After reading this post, you should have a clear understanding on how lenders determine their rates, so you can select a loan product that you can comfortably afford.
How Do Lenders Determine Loan Rates?
To understand how financial lenders determine their 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. Return
Before a lender sets up shop, they establish criteria for the investments (i.e. loans) that they’re willing to make. One of the lender’s most important investment criteria is the risk and return profile.
A lender’s risk and return profile determines how much risk the lender will take in exchange for a certain level of expected return. Since more risk must be justified by a higher potential return, riskier 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 Demand
When 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 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 Interest Rates
As an individual, you can’t affect market and regulatory forces; even 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
The total costs vary from lender to lender and can greatly impact the interest rate you pay. Everything from a lender’s investors, business model, and efficiency can determine how competitive their rates are.
In addition to costs, individual lenders also have various levels of lending capacity, both in terms of human resources and capital. In other words, lenders can only lend as much as they have the money and staff to handle.
If a lender is at or near capacity, they may increase rates to slow business down. Alternatively, if they’re not on pace to lend as much as they wanted to, they may decrease rates.
This variety of lender-specific forces is why it’s so important to shop around when seeking financing. Prior to submitting a loan application, you should weigh your options to ensure you select a loan amount with rates that you can handle throughout the life of the loan. If not, your business’s cash flow and overall future may be affected.
Conclusion: Put Yourself in the Lender’s Shoes
In any business transaction, it’s smart to evaluate the deal from both sides. The same is true when it comes to finding the best business loan rate possible. Certain broad economic conditions create environments in which business loans are exceedingly affordable.
At the same time, industry-specific trends may also impact business loan rates. Due to this, it’s important to consider all of these factors when pursuing a business loan or other type of additional financing (such as lines of credit).
While you can’t predict the future, you can identify the scenarios in which you’re most likely to get a great rate on a small business loan. Therefore, even if you’re not actively looking for business financing, understanding what determines interest rates will help you identify opportunities when they come.
If you’re ready to pursue additional financing for your business, click the link below to get your free quote from Fora Financial.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.