Is the Interest Rate on My Business Loan Too High?
Interest rates for business loans can range from single digits to over 40%. While everybody understands that a lower rate is preferred, there is a lot of confusion about what interest rates are too high.
So, at what point is an interest rate too high? The truth is that there is a different answer for each business. It depends on three things:
- Your risk profile
- Your options
- The opportunity
In this article, we'll dive into these factors so you can understand how to answer the question for yourself and make the best decision for your business.
1) Your Risk Profile
Lenders provide the best rates to those with the best risk profiles. To determine your risk profile they will take into account many aspects of your business and yourself (see the examples below).
It is important to have realistic expectations of your rate, which is based on your unique risk profile. For example, it's fair to say a single digit rate is reasonable for someone with a great risk profile: 800+ credit score, long and successful history running the business, millions in revenue, strong and consistent profit, and plenty of collateral. If your risk profile decreases in quality, your rate will rise.
Risk Factor Examples
- Personal Credit Score - The strength of your personal credit score has a direct impact on the interest rate you'll qualify for. Typically, borrowers with a higher credit score may get a lower interest rate. Your credit score rating reflects how responsible you are with your finances. If you score shows that you are a reliable borrower, lenders will trust that you'll pay back the loan on time. This confidence they have in you will be reflected in the interest rate they charge.
- Time in Business - A lender may see a business as more or less risky depending on how old it is. Most lenders consider businesses that have been operating for less than two years as risky. Due to this, lenders charge a higher interest rate for younger businesses.
- Your Business Financials - The better your business is doing financially, the more likely you'll be able to repay your loan. Lenders place a good value on a business' revenue and profitability. Some lenders have revenue minimum requirements for your business to be eligible for a loan. For example, at Firma we require you to have at least $100,000 in revenue to qualify for loans.
- Your Industry - Your interest rate can also depend on how risky your industry is. For example, restaurant owners may have a harder time finding great interest rates due to the high turnover and failure rates in the industry. Generally, the more unstable or speculative the industry is, the higher the rates you can expect to see.
2) Your Options
Most small businesses aren't able to qualify for a bank loan so they turn to alternative lenders. If your business isn't able to get a loan from the bank, then it isn't reasonable to compare interest rates between a bank and an alternative lender. You should only compare interest rates between the options for which you are able to qualify.
Additionally, alternative lenders are able to charge premiums on the interest rates they provide because of the speed, term lengths and convenience their services provide. Below are the advantages these aspects give small businesses.
- Speed - The technology alternative lenders use allows them to provide approvals in as fast as 1 day. Meanwhile, an application with a bank could take weeks or several months to process.
- Term - Alternative lenders are able to provide short-term financing that banks won't consider.
- Convenience - Alternative lenders often have online applications that can be done in a few minutes. In contrast, applying for a bank loan usually requires lots of paperwork and visits to a bank's branch.
3) The Opportunity
An opportunity cost is the benefit you give up when deciding to choose one alternative over another. This type of trade-off is inevitable when running a small business with limited time and resources. Regardless of how high the interest rate you get, it may still be in your best interest to pursue a project if you'll still profit from it.
For example, imagine you were presented with a project that would give you $50,000. However, to complete this project you would need to buy $10,000 in new equipment. Getting a $10,000 loan could cost $3,000 in interest. You may find this interest high, however, if you were to take this loan, you would still profit from the new project. The total cost of the loan would be $13,000 while the project pays $50,000 leaving you with $37,000 in profit.
If you're trying to decide whether an interest rate for a business loan is fair, keep in mind your business' risk profile and financing options. You should also assess if the cost of getting the loan would still allow you to profitably pursue a new opportunity.
Many small business owners find the traditional way of using Annual Percentage Rate helpful in comparing loans, but don't know that it's misleading when understanding a loan's actual cost. Due to this issue, many alternative lenders use Annual Interest Rate to communicate the cost of their loans.