How Lenders Determine Your Interest Rate
Lenders don’t choose rates at random. They perform a detailed risk assessment based on several key factors to determine the rate you’re offered. Understanding these factors can empower you to improve your company’s financial profile.
- Credit Scores: Lenders evaluate both your personal FICO score and your business credit score. Higher scores demonstrate a history of responsible borrowing and can unlock lower interest rates.
- Time in Business: A longer operational history suggests stability. Most lenders prefer to work with businesses that have been established for at least two years, as startups are generally considered higher risk.
- Annual Revenue and Cash Flow: Strong and consistent revenue proves you have the means to make regular loan payments. Lenders will analyze your cash flow to ensure you can handle the additional debt.
- Industry: The risk associated with your industry plays a role. Businesses in historically volatile sectors like restaurants or retail may face higher rates than those in more stable industries like healthcare or professional services.
- Collateral: Offering collateral—such as real estate, equipment, or inventory—secures the loan. This reduces the lender’s risk, as they can seize the asset if you default. In return, they often offer a significantly lower interest rate compared to an unsecured loan.
Fixed vs. Variable Interest Rates: Which Is Better?
Business loans typically come with one of two types of interest rates, each with distinct advantages and disadvantages.
- Fixed Interest Rate: The rate is locked in for the entire loan term. This provides predictability, as your monthly payment never changes, making it easier to budget. It’s an excellent choice if you prefer stable, consistent costs.
- Variable Interest Rate: This rate is tied to a benchmark index, such as the Prime Rate. It can fluctuate over the life of the loan, meaning your payment could rise or fall. While variable rates often start lower than fixed rates, they introduce uncertainty into your long-term financial planning.
Don’t Forget the APR
While the interest rate is a primary factor, the Annual Percentage Rate (APR) provides a more complete view of a loan’s cost. The APR includes the interest rate plus other lender charges, such as origination fees, processing fees, and closing costs.
Example:
Imagine you need a $50,000 loan.
- Loan A: Offers a 7.5% interest rate, but with high fees, the APR is 9.5%.
- Loan B: Offers an 8% interest rate, but with low fees, the APR is 8.25%.
Loan A’s interest rate looks more appealing at first, but Loan B is the more affordable option once all costs are included. Always use the APR for an accurate, apples-to-apples comparison.
Actionable Tips for Securing a Lower Rate
- Strengthen Your Credit: Before applying, review your personal and business credit reports. Pay down existing debt and dispute any inaccuracies to improve your scores.
- Prepare a Solid Business Plan: Present lenders with a comprehensive business plan that includes detailed financial projections. This demonstrates that you have a clear strategy for growth and repayment.
- Shop Around: Don’t accept the first offer. Compare terms from traditional banks, credit unions, and reputable online lenders to find the most competitive APR.
- Offer Collateral: If you have valuable assets, consider using them to secure the loan. The reduced risk for the lender often translates into a better rate for you.
Frequently Asked Questions (FAQs)
What is a good business loan interest rate?
A “good” rate is relative and depends on the prime rate, your industry, creditworthiness, and the loan type. As of early 2024, rates for traditional bank loans can range from 6% to 10% for the most qualified borrowers, while online lenders and SBA loans may have different ranges.
Does my personal credit matter for a business loan?
Yes, for almost all small businesses, it is a critical factor. Lenders view the owner’s personal credit history as a strong indicator of their financial discipline and the business’s likelihood of repaying the loan.
Why is the APR always higher than the interest rate?
The APR includes both the interest rate and any additional lender fees (like origination or administrative fees) rolled into the loan. Because it captures the total cost of borrowing, it is a more accurate measure for comparing loan offers.
Will my bank automatically give me the best rate?
Not always. While your bank is a good starting point, it’s wise to shop around. Online lenders and credit unions are highly competitive and may offer more favorable terms or have more flexible qualification criteria.
Learn more about managing your company’s finances by exploring our guides on Business Credit Scores.