When you’re searching for a business loan, you’re likely very aware of the interest rates available. Once you’ve been approved, your loan is funded, and you enter the repayment period, the interest rate goes into effect.
Many small business owners ask, “How does interest work on a business loan?”
In this Q&A, you’ll learn everything you’ve wanted to know about how interest works. Find out how interest changes as you pay down your loan, how refinancing at a lower interest rate can improve cash flow, and much more.
What is interest?
In simple terms, interest is the cost of borrowing money. Interest is included in short-term loans like credit cards and lines of credit and longer-term loans. It might also be part of leasing equipment and machinery, or you could accrue interest on savings and investment accounts.
As you can imagine, lenders have expenses related to lending money. The interest collected over the life of your loan, along with any fees you pay, covers those expenses. In the case of for-profit lenders, like banks, interest also contributes to profits on the money they lend.
You’ll see that loans have fixed or variable interest rates that will impact your cost of borrowing over time. When you’re evaluating your options, it’s a good practice to compare loans based on the annual percentage rate (APR). This calculation takes into account the interest rate as well as the loan amount, term, repayment, fees, and more. The APR of the loan will give you a more “apples to apples” comparison between loan products.
Interest rates vary from loan to loan and are determined by many different factors. Your lender will consider your credit score, your industry, and more. Ask your lender for more information on how the rates are calculated for their loan products.
Is interest a one-time fee that I pay when my loan closes?
No, interest isn’t a one-time fee. It’s something that you’ll pay as long as there’s an outstanding balance on your loan. Each payment goes toward your interest and the principal, which is the original amount of the loan.
That said, many lenders do have one-time fees that are paid when you apply for a loan, when you close or both. Some of the fees can be financed into your loan so you’ll pay them off over time. Reputable lenders will outline these fees for you upfront, but don’t be afraid to ask about the fees if you need more information. If your lender is dodging your questions about fees and hasn’t told you about any during the application process, this could be a red flag that you’re working with a predatory lender.
How does interest work on a loan?
While lenders can set different terms for every loan, most loans have similar repayment structures. If you have a monthly payment, then the interest on your loan builds up over the number of business days in a month. Some months have more business days than others, so you’ll see your interest amount vary a bit from month to month.
Let’s look at an example. You have your original loan for $200,000, and the current principal balance is $150,000. The amount of interest charged for this month is calculated on the outstanding balance of $150,000 over the number of business days in the month, not on the original loan amount of $200,000. This is a simple explanation of how interest works on a loan.
As you review your monthly statements, you’ll notice a change in the division between principal and interest. Over time, even though your monthly payment amount stays the same, you’ll see that the outstanding principal balance goes down and the interest portion of your monthly payment will decrease, too. With every payment you make, more of it will go toward paying down the principal and the interest owed will be a little less each month.
For some loans, you can make extra payments in between your scheduled payments that will go straight toward your principal. With that, you’ll see your interest decrease even more over time as there’s less of the principal left to calculate the interest.
How often do I pay my business loan?
It depends! Your loan-repayment schedule is set up by your lender. For most loans, payments are due once a month.
There are some lenders with more aggressive repayment requirements who take automatic payments weekly and even daily. Often, these lenders fall into the “predatory” category, because these repayment terms are hard for small business owners to manage. If you think you may have dealt with a predatory lender, you’ve got options! You can refinance that high-cost debt into a more manageable term loan with a reputable lender.
What’s the difference between a fixed interest rate and a variable interest rate?
With fixed-rate loans, the interest rate stays the same throughout the life of the loan. With variable-rate loans, the interest rate can change and it often increases several times over the course of the loan period.
If you are looking for a more predictable option, a fixed-rate loan can give you just that. Your interest rate won’t change during the life of your loan and your monthly payment amount will be the same each month. Variable-rate loans can change with economic conditions beyond your control. In either case, if interest rates fall you can always try to refinance your debt into a lower-cost loan.
I have a business loan from Pursuit but I don’t have a schedule that shows how much interest I’ll be charged each month. Can I get one?
What’s mentioned in this question is called an amortization schedule. This document shows each of your monthly loan payments and breaks down how much will go toward interest and how much will go toward your principal.
Pursuit doesn’t provide amortization schedules, which are charts that show how much of each monthly payment will go to principal and how much will go to interest over the life of the loan. Because the number of business days in a given month varies, the schedule may not exactly match the interest that actually accrues.
For example, February has fewer business days every year because it’s a shorter month, so there are fewer days over which interest will accrue. A month like August will have more business days, so the interest charge for the month will be higher.
Given this, you may not know the exact amount of interest you paid in any given month until after the payment is made and you review the next month’s statement. This will show how the previous payment that you just made was allocated toward principal and interest.
How can I reduce the interest that I pay each month?
There are two ways to reduce the interest that you pay each month:
- You can refinance your existing loan with a lower-interest-rate loan. You want to make sure that you don’t have to pay prepayment penalties on the original loan, otherwise, the penalties might offset the benefits of refinancing.
For example, many Pursuit clients who started with Pursuit SmartLoan refinance that into an SBA 7(a) or Microloan. Having these options helps you improve your business’s finances for both the short term and the long term.
Some lenders will let you refinance existing SBA loans with new SBA loans, too. The lender may give you this option if the interest rate is lower and will help free up working capital to continue building your businesses.
Let’s take a look at an example. Clementina Richardson, founder and co-owner of Envious Lashes, grew her high-end brow and lash business from the ground up. As the business grew and grew, Clementina and her business partner and husband Michael opened new locations. Their high-cost debt was doable when their business was running in full swing, but when the pandemic temporarily closed their locations, it was time to review their financials.
Clementina and Michael talked to Pursuit about their options and were approved for an SBA 7(a) loan to refinance and consolidate their debt. They lowered their monthly payments by 40% and freed up more working capital to relieve financial pressure on the business.
- If you make additional payments to the principal to lower that amount, you’ll reduce the interest that accrues each month. That’s because interest accrues on the amount of the outstanding principal. Even a one-time extra payment toward principal will give you a lasting reduction in the interest you pay from that point on.
How do I know if my current business loan has the best interest rate for me?
The easiest way to determine if your loans are optimal for your business is to talk to your loan officer. They can review your loans and learn about your financial goals for your business.
They’ll take a look at your financials to see if there’s a better loan option to refinance your current loan, or if there’s another option to give you a boost. Staying in touch with your lender keeps them updated on your goals and progress, and keeps you updated on any new products or services that can benefit your business.
Pursuit can help
When you need financing, you want to work with a lender that’s dedicated to your success. That’s Pursuit! We offer more than 15 small business loan programs along with support services that are specifically designed for your unique needs. We’re committed to helping your small business thrive.
Contact us today to learn more about how we can help.
