Do you need extra capital for your small business? If you’re thinking of securing a business loan, you should know how much it’s really going to cost you.
Before taking out a new loan, understand how business loan rates and fees work.
Business loan rates and fees
Unexpected expenses can lead to negative cash flow and a drop in your company’s bottom line. You probably know that your loan amount is less than what you’ll end up paying back … but how much less?
The following are standard small business loan rates and fees you may face.
Interest rate
When you take on small business loans, you are responsible for paying interest. What is interest? Interest is a percentage of the principal that is tacked onto what you owe. Principal refers to both the original amount of the loan as well as how much you still owe on it.
A business loan interest rate is determined by factors like credit score, how long you’ve had your business, loan repayment period, and loan amount. If lending to your business is risky, your interest rate will generally be higher.
There are two types of ways that interest rates are calculated: simple interest and compound interest.
Simple interest
Simple interest is a percentage calculated on the original amount of the loan.
To find your simple interest rate, multiply the principal by your interest rate. Then, you can multiply it by how many years it will take you to pay off the loan to determine the total amount of interest you will owe.
Use the simple interest formula to determine your total interest liability:
Simple Interest = Principal X Interest Rate X Number of Years
Let’s say you borrow a $20,000 loan at an annual interest rate of 5%. Your repayment period is four years.
Simple Interest = $20,000 X 0.05 X 4
Simple Interest = $4,000
Over the course of four years, you will owe an additional $4,000 in interest to your lender.
Compound interest
Unlike simple interest, compound interest is calculated on both the principal and the interest earned. Compound interest is more complicated to calculate.
To find compound interest, you must add together the principal and interest earned. Then, multiply that number by the interest rate.
Compound Interest = (Principal + Interest Earned) X Interest Rate
Pay attention to how frequently the interest compounds. For example, some interest rates are compounded monthly while others are compounded annually.
Origination fees
Interest rates aren’t the only additional amounts you need to be wary of when you take out a loan. Familiarize yourself with origination fees, too.
Origination fees are generally a percentage of the principal. Lenders charge origination fees to cover administrative costs.
The origination fee might include an application fee, or you might have a separate fee to cover application processing.
Underwriting fees
To verify your loan application, your lender may need to hire an underwriter. An underwriter reviews applications to check for accuracy and determine how risky it is to lend you money.
Late and early payment fees
If one of your loan payments is late, your lender might charge a fee. If you want to pay off your loan earlier than your agreed payoff date, you may also have a fee.
Your total business loan rate doesn’t include late and early payment fees, but you should be mindful of them.
To prevent late payment fees, ensure you have enough funds to pay on time. And, set reminders so you don’t forget to make payments.
To avoid surprise early payment fees, determine if your lender charges penalties before you sign your loan agreement.
Total business loan cost: annual percentage rate
The annual percentage rate (APR) expresses your total loan amount. APR is a combination of your interest rate and other loan fees. If your lender compounds interest, keep in mind that APR does not take compounding into account.
Small business loan rates could be as low as 4% or as high as 80%, depending on the type of loan you need.
Let’s say you take out a loan that has an interest rate of 4% and 2% in fees. Your APR would be 6%.
Business loan alternatives
If you decide that business loan financing isn’t right for your business, you have other options.
Instead of seeking business loans, you can appeal to investors. Investments may come from either angel investors for small business or venture capitalists. To secure investments, you need to have things like a business plan and an exit strategy.
Depending on how much capital you need, credit cards might be an appropriate financing option. However, don’t depend on credit cards for large sums, as interest rates are generally higher than business loan rates.
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This article is updated from its original publication date of September 6, 2018.
This is not intended as legal advice; for more information, please click here.