Interest is the cost of borrowing money or the reward for saving it. It’s given as a percentage of the amount (principal) borrowed or saved. For the purposes of this article, we'll focus on the interest charged on business financing, particularly term loans.
Interest is the first incentive banks and other lenders have for offering loans, lines of credit, asset financing, and credit cards. Actually, charging interest on financing is one of the main ways lenders and banks make money. According to the Federal Deposit Insurance Corporation (FDIC), U.S. banks made $279.1 billion in 2021, mostly from credit activities.
To the borrower, interest is an inevitable cost of funding and a crucial variable in loan ROI and debt management. The final cost of financing mainly depends on the associated interest type and interest rate. Let’s look at the common types of interest and how lenders determine the rates for various products.
Types of interest for business financing
Before taking a business loan, ensure you fully understand the cost structure. That should give you an accurate figure of the loan's short-term and long-term costs as well as repayment obligations. Here are the types of interests you’ll find in most business financing offers:
Annual percentage rate (APR)
APR represents a loan's total cost, including fees and interest, expressed as an annual ratio of the principle. The Truth-in-Lending Act (TILA) requires that lenders disclose the total finance charge over a loan’s lifetime. So, it makes sense to round up all the associated charges (origination, underwriting, insurance, payment fees, etc.) and the interest into one easy-to-digest figure. However, the APR may not include application fees and other out-of-pocket charges.
This is a common costing approach for long-term and short-term loans, lines of credit, and business credit cards. Monthly repayments are determined using an amortization schedule, where the borrower pays down the principal and the accrued interest over time. You can use this APR loan calculator or the formula below to work out the installments and total cost of amortized interest.
Fixed interest
A fixed-rate loan means that the interest remains constant throughout the repayment term. Fixed-rate can be a standalone interest or included in an APR. With fixed interest, you know exactly how much to pay each month and the total interest accrued over the loan’s lifetime. You can get fixed rates on long-term business loans, mortgage loans, asset financing, and even lines of credit.
Most borrowers favor fixed-rate financing for its stability. You pay the same amount regardless of changes in the economy or financing market during the loan’s term. Plus, a fixed-rate loan makes for straightforward repayment budgeting.
While shopping for fixed-rate loans, watch out for products that are sometimes falsely advertised as having a fixed rate. In some cases, the fixed rate only covers part of the loan term, after which the interest is subject to change. Such loans are known as split-interest loans.
Variable interest
Unlike fixed interest, variable or floating interest is not constant. It fluctuates to reflect changes in the overarching prime interest rate. The prime interest rate is a lowered rate that commercial institutions and banks charge their most favored or creditworthy borrowers. Every lender’s prime rate is determined by the Federal Reserve lending rate, which varies depending on the prevailing economic atmosphere and financing demand.
If the federal funds rate rises, so does the prime rate. In such a case, the borrower pays a higher interest. On the other hand, the borrower can take advantage of lowered rates to make considerable savings on repayments. In the end, variable interest favors either the borrower or the lender (but mostly the borrower), depending on the market dynamics during the loan term. This unpredictability can make planning repayments and calculating costs quite difficult.
However, floating-interest loans generally have lower starting rates and higher limits than their fixed-interest equivalents. Though, variable-interest financing is best suited to enterprises with a lot of wiggle room in their cash flow.
Simple interest
Simple interest is determined by multiplying the given rate by the loan's principal. In some cases, it represents the total interest payable on a loan throughout its entire term. You may find this arrangement in short-term, low-limit loans payable within a year.
It may also be given as a daily, weekly, bi-weekly, monthly, quarterly, or annual rate. With simple daily interest, for example, a small rate (less than 1%) is charged daily and cumulated for the number of days between payment cycles. This is a common costing structure for most merchant cash advances and some business credit cards. Below is the formula for calculating simple interest with a periodic rate:
Compound interest
With compound interest loans, you pay interest on both the principal and the interest incurred over time. It’s calculated by taking the interest and adding it back (compounding) to the principal at a set frequency, weekly, monthly, quarterly, annually, etc. The debt grows exponentially throughout the term, and the higher the compounding frequency, the faster the debt grows. Here’s the formula for calculating the total repayment amount on a compound interest loan:
Compound interest is rare in mainstream business financing due to its exorbitant nature. But some opportunistic merchants, vendors, and lenders mark up their loans with compound interest, mainly targeting borrowers with no other options.
What determines the interest type and rate?
Interest types and rates vary between lenders and products. Knowing how lenders price various financing products can help you position your business for favorable interest terms. On that note, here are the main factors that determine lending interest:
- The Federal Reserve lending rate – This depends on the economic climate, and there's nothing that lenders or borrowers can do about it.
- The loan type – Different loans have different interest structures and rates. For instance, the average interest on SBA loans currently ranges between 2.75% and 12.75% depending on the product.
- Lending risk index – Lenders evaluate lending risks based on various factors, including credit score, cash flow, collateral, and business history. The higher the risk index, the higher the rate.
- The lender – Every lender is at liberty to set interest however they see fit. But institutional lenders and banks have standardized and regulated interest terms that tend to favor borrowers. However, many small businesses find it challenging to qualify for bank loans.
Get the best interest rates with Lendzero
As a loan costing metric, interest is carefully structured to cater to the prevailing economic climate, the borrower's risk level, and the type of financing. But to the borrower, the type of interest and rate on any loan largely comes down to the lender. The key to finding the best rates is shopping around and comparing what different lenders have to offer. And that’s where Lendzero comes in.
Lendzero is an online platform that lets you navigate the world of business financing with ease. It matches your business with various funding solutions from multiple lenders, merchants, and vendors. Moreover, all the offers are pre-negotiated for business-friendly terms and interest. Lendzero is your go-to financing assistant for finding the best deals. The beauty of Lendzero is that it doesn't cost you a thing; just sign up, fill out your business profile, and you're good to go.
