How are Interest Rates Calculated?

Interest rates calculate business owner

When you’re exploring business loan options, one of the most important (and mysterious) aspects is the business loan’s interest rate.

To help you understand what goes into an interest rate calculation, we asked Chris Levy, executive vice president at Pursuit, to help break it down.

Q: Can you tell us about the factors that lenders consider when determining business loan interest rates?

A: One of the most important factors is creditworthiness. Lenders consider your business’s past performance, cash flow and future prospects. They also look at your personal financial history and  personal credit score to get a fuller sense of how you manage debt. Often, the higher the personal and/or business credit scores, the more favorable the rate.
Collateral can be another significant factor. When lenders have access to equipment or real estate, it provides security that they can recoup some of the loan debt if the business has to close. That’s why SBA 504 loans tend to have lower interest rates than a Pursuit SmartLoan. SBA 504 loans are secured by commercial real estate and other tangibles, while SmartLoans aren’t necessarily secured by any collateral.

There are many factors that go into overall loan approval, but these are the two most significant factors when determining interest rates offered on loans.

Q: Interest rates were at “all-time lows” in 2021. Why does it seem like many small business loans still have higher rates?

A: It’s true that rates were historically low for government bonds and for highly collateralized loans, like residential mortgages in 2021. Small business loans, though, are based on the risk profile of the business and its owners. Lenders want to help, so they work to find the right balance of risk and return.

Think of it this way: When you apply for a residential mortgage, you go through an extensive process, even with the collateral that you put toward the loan (your house). Similarly, to get the most beneficial interest rates and terms for your small business, you’ll need to go through a more extensive underwriting process, as is the case for most SBA loans.

Q: How do interest rates on quick-turnaround online loans typically compare to SBA loans?

A: Generally speaking, programs that offer a quick turnaround are going to have higher interest rates than SBA loans. This is because in the lending world, fast access to cash is a luxury — and borrowers pay for that luxury through higher interest rates. With fast access loans, lenders perform less due diligence up front, they take on higher risk overall, and the cost of that risk is then passed on to borrowers in the form of higher interest rates.

It’s also not unusual for those loans to have adjustable interest rates, which means that the required payments can increase over time. Another issue to watch out for is challenging repayment terms. These loans may require payments that are due daily or weekly, rather than monthly.

Q: Why are the interest rates on some government loans, like SBA 7(a) and 504 loans, higher than other government loans, like the SBA Paycheck Protection Program (PPP) loan, which has a 1% interest rate?

A: Programs like PPP were tied to specific government assistance programs to provide small businesses with support during the pandemic.

Having said that, some ongoing loan programs may offer reduced rates if borrowers are veteran-, women- or minority-owned businesses. There may also be reduced-interest options if businesses are located in target “opportunity” zones or rural areas, for example.

To ensure that you get the best rate, talk to your lender or contact Pursuit. If you’re eligible, we’ll help you find these specific potential interest-rate reductions.

Q: What are some of the other benefits that potential borrowers should consider when deciding between loan options?

A: Interest rates are certainly a key consideration, but you also want to ensure that the repayment terms are manageable for your business and that there are no prepayment penalties. Often, quick-turnaround online lenders charge prepayment penalties, and this can really add up if you try to pay off or refinance a loan.

Another very important factor is that you want a loan with a fixed interest rate. Many quick loans offer low rates for the early part of the term (for the first three or six months, for example), then they raise the rates. This can really throw off your cash flow. A fixed interest rate for the life of the loan means you can budget your repayment without any surprises.

It’s also really important to beware of upfront fees. While these are not specifically tied to interest rate, they do impact the overall “cost” of the loan. Some loans may be masked with loan interest rates but feature large upfront fees that make the loan appear attractive. Make sure that you’re aware and notified of all potential fees before you sign off on your loan.

Q: Do you have any additional insight to share on this topic?

A: Keep in mind that the best loan programs are developed to do more than cover immediate expenses. Business loans should help your business grow. A lot of small business owners don’t consider debt that way – they try to avoid it – but if you have the right guidance and strategy in place, you can work business loans to your advantage. It helps to talk to your advisors or Pursuit, even if you’re not actively looking for funding now.

Pursuit can help

We offer access to more than 15 small business loan programs and a range of additional services, we’re committed to helping your small business get stronger today and thrive tomorrow.

To learn more about how we can help you, contact us today.

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