As a business owner, there are a number of reasons why you might want to take out a loan. Not only can it help you ride out periods where cash flow is low, it can propel your business to greater heights by providing funding for new equipment, renovations, and extra staff.
But there’s more to business loans than just making your way down to your local bank branch. You’ll also need to take into account the types of interest. And while you might think business loans operate much the same way as personal loans, the truth is the way you pay interest can be quite different.
Here’s a rundown of the types of interest rates you’ll encounter when taking out a loan and the ways they’re calculated.
Fixed and variable business loan interest rates
The interest rate is the percentage of the principal amount you have to pay on top of what you’ve borrowed, and can be fixed or variable. These are used by mainstream banks more than online lenders. With fixed interest rates, you’ll know upfront how much you’ll be paying over the life of the loan, so you’ll be able to play it smart and budget around your monthly repayments.
Variable interest rates, on the other hand, are set according to the RBA cash rate, and are subject to fluctuations over the life of the loan. This can be a good thing or a bad thing. If the cash rate is cut, variable rates will likely follow suit, and you’ll pay less on your loan during this period.
If the cash rate is increased, however, you could wind up paying more than you expected. The silver lining here is that variable rate business loans tend to be more flexible and many lenders will let you pay off your loan early without charging you any extra fees.
Combination fixed and variable
This is sometimes offered by lenders in the initial stages of a loan. You might have a fixed rate for the first year or two, but after that it will revert to the standard variable rate.
Factor rates differ from interest rates in that they’re expressed as decimals, rather than percentages. They typically range from 1.1 to 1.5, and are applied to your loan amount to let you know exactly how much you’ll be paying.
For example, a factor rate of 1.2 means you’ll need to pay 1.2 times the principal amount, so a $50,000 loan will cost you $60,000 in total, including interest.
You’ll need to keep your wits about you when dealing with factor rates. They might look good at face value but they could wind up costing you more in the long run.
For one thing, factor rates are charged when the loan is issued, and remain fixed regardless of how quickly you pay it back. Unlike percentage based interest - which is charged on the principal and decreases in proportion to how much has been paid off - you won’t be able to put yourself in a better position by paying off your loan early.
What affects how much I’ll pay?
Interest rates for loans will differ depending on the characteristics of your business and the type of loan you’re after. When deciding how much you’ll pay on top of your loan, lenders consider a few things. These include:
- The length of loan: Lenders typically charge higher rates on short-term loans than they do on long-term loans. That said, a short term loan can save you on interest in the long run, given that you pay it off faster, so you’ll have to weigh the pros and cons.
- If your loan is secured or unsecured: Unsecured business loans - in which the borrower hasn’t put up property or assets as collateral - will usually come with higher interest rates, since the risk is higher for lenders. Secured loans will also differ depending on the kind of security. If you’re looking at a property secured loan then you’ll get a much better rate than if you’re relying on invoice financing.
- How long you’ve been in business: Lenders will take into account the length of time your business has been operating. Considering most businesses fold within the first three years, being able to show that your business has been running for longer than that is a good way to vouch for its health.
- Your net profit: How much your business makes in a year (minus tax and expenses) will play a big role in determining your eligibility for a loan plus how much you can borrow.
When is interest calculated?
Here’s where it gets confusing. There’s no set formula lenders follow when calculating how you’ll pay interest, so things differ across the board. Some might charge 5.00% per month, while others charge 1.00% per month. Some charge 1.00% per fortnight, some charge less.
Not having any hard and fast rules when it comes to interest means they can also be quite secretive. Unlike personal loans, which have become more up front over the years about things like extra fees, business loans aren’t so immediately transparent.
So before you go taking out a loan, you’ll really need to shop around to see which lender will provide you with the best deal. For an idea of what’s available, don’t hesitate to check out our business loans comparison page.