How to Ensure Your Financing Isn't Overextending the Capabilities of Your Business Tips for small business owners on how to evaluate potential interest rates on loans as well as the steps they can take to lower their rates.
By Joseph Camberato Edited by Chelsea Brown
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Small business financing can help your business get to the next level, and there are multiple factors you should consider when evaluating loan offers. While the interest rate doesn't tell the whole story, it is a significant factor that can't be overlooked.
Your interest rate determines how much you'll pay over the life of the loan, and a low rate leads to lower monthly payments and increased savings. Alternatively, an interest rate that's too high can lead to financial instability.
Whether you're looking to take out a loan in the near future or later on in the year, it's a good idea to understand how to evaluate potential interest rates and the steps you can take to lower your rate.
Related: 8 Things Entrepreneurs Should Look for When Getting a Business Loan
How to evaluate the interest rate on a small business loan
Here are some factors you can use to evaluate interest rates:
The lender: Your interest rate will vary depending on the type of lender you work with. For example, banks and credit unions tend to offer the lowest interest rates on business loans. Nonbank lenders may offer slightly higher rates, but the application process is more streamlined, and you'll receive the funds faster.
Fixed vs. variable rates: When you take out a business loan, you'll receive either fixed or variable interest rates. A fixed-rate loan will stay the same over the life of the loan, while variable interest rates will change depending on current market conditions. In the beginning, a variable rate may be lower than a fixed interest rate, but this can quickly change if certain indexes — like the prime rate — go up or down.
The loan terms: It's also important to consider the loan terms you're offered. For example, let's say you're comparing a loan with three-year terms vs. 10-year terms. The 10-year loan terms may come with a slightly higher interest rate but lower monthly payments. In comparison, you'll pay less interest overall on a three-year loan, but your monthly payments will be higher.
The financial health of your business: Finally, you need to consider the overall financial health of your business. Would the interest rate negatively impact your overall cash flow and ability to repay the loan? If the payments put a significant strain on your business finances, the loan may not be worth it.
The interest isn't the only factor that affects how much you'll pay for the loan. Some lenders charge additional fees, like origination fees, application fees or closing costs. The fees will drive up the total cost of the loan, so you should talk to your lender and ask them to outline what fees you'll have to pay.
Related: 5 Ways to Avoid Paying Too Much on a Business Loan
3 ways to lower your interest rate
The rate you receive on a business loan depends on a variety of factors, including your business finances, credit score and the industry you're operating within. If the rate you're offered is higher than you'd like, here are some steps you can take to lower it.
1. Improve your credit score:
In addition to checking your business credit score, your lender may look at your personal credit score. If you have poor personal credit, this can affect the rates you receive on a business loan or make it hard for you to get approved.
To improve your credit score, focus on lowering your credit utilization rate by paying down as much debt as possible. You should also pay your bills on time since late payments can stay on your credit report for up to seven years.
2. Put down collateral:
Your lender may be willing to give you a lower interest rate if you put down some type of collateral on the loan. Collateral lowers the risk to your lender since they can seize the collateral if you default on the loan.
You can use cash or a tangible asset, like equipment or inventory, for collateral on a loan. However, you should make sure you're confident about your ability to repay the loan before putting down collateral.
3. Shop around:
The rates offered by different lenders can vary widely, so the best way to save money on interest is by shopping around. Choose several different lenders, and get prequalified with each one, comparing the rates and terms offered by each.
Of course, filling out multiple business loan applications can be a little tedious. Another option is to use a lending marketplace — you'll apply once and receive offers from multiple lenders in one location.
Related: How to Choose the Best Small Business Loan for Your Needs
Next steps
When it comes to small business loans, what's considered a "good" interest rate will vary. An interest rate that is acceptable for one business owner may be way too high for someone else.
It's important to make a decision based on the financial needs of your business. Consider all your options, and work with a lender you trust so you can find the best financing options for your business.
