Money is more than cash in your pocket. It’s a tool that allows you to perform a service or deliver a product. In the same way that a carpenter needs a saw, your business needs capital to operate effectively. When you borrow that capital, you’re essentially renting a tool to help your business achieve its goals. Your business pays for this “capital rental” over time through interest and fees.
Before finalizing a loan, be sure you understand your total borrowing costs. This knowledge will help inform your strategy and put you on the right path toward borrowing successfully.
Interest is how lenders make money
Every loan has three parts:
- Principal — The amount of money borrowed
- Interest — The price of borrowing that money
- Fees — Charges that vary by lender and type of loan
After the principal, interest is typically the next most expensive part of borrowing. Most business loans incur compound interest, which charges borrowers interest on both the principal and any previously accumulated interest. This is why it’s sometimes called “interest on interest.”
It’s important to factor in how often your interest compounds. Interest that compounds daily, for example, will add up much faster than interest that compounds monthly or yearly. The longer the loan term, the more you’ll owe, because the interest compounds more often.
How are interest rates determined?
The interest rate on your loan doesn’t exist in a vacuum–it’s influenced by the larger national economy. Interest rates are closely tied to the federal funds rate, which is the interest rate set by the Federal Reserve to guide economic policy.
The federal funds rate informs the prime rate, the interest rate given to the very highest-quality borrowers. Your interest rate might be a little or a lot higher than the prime rate depending on your credit history and the type of credit you’re pursuing.
The following factors also determine your specific interest rate:
- Type of credit — The riskier the type of credit, the higher the interest rate. Credit cards are likely to have the highest interest rates because they’re the easiest to qualify for and rarely require collateral. A line of credit typically charges a moderate rate, and a term loan often charges the lowest.
- Credit score — Both your personal and business credit scores play an important role in determining your interest rate. Your scores incorporate your payment history and other factors that help lenders evaluate how likely you are to pay them back. Borrowers with high credit scores usually qualify for lower interest rates than borrowers with lower credit scores.
- Business health — Lenders want to see that your business has a strong foundation. If you’re applying for a line of credit or a loan, be ready to show financial documents like profit and loss statements, cash flow statements and balance sheets. An established relationship with your lender or a long business history can also demonstrate your business’s financial health.
How terms affect payments
Consider your cost per month when determining whether you can pay back a loan. In general, longer-term loans accrue more interest but have lower monthly payments, while shorter-term loans accrue less interest yet cost more per month. Even a modest loan could create financial stress or result in fees and penalties if you have to pay it back too quickly.
Watch out for fees
Most borrowers incur fees that vary by lender and type of credit. Common fees include:
- Origination fee — A one—time fee incurred when you first open a line of credit or get a loan
- Service fee — Repeat fees that help cover general administrative costs for the lender
- Prepayment penalty — A one-time fee for borrowers who pay off their loan early, because early payment reduces the lender’s expected revenue
- Payment penalties — Various fees that cover payment issues like late payments or insufficient funds
The APR, or annual percentage rate, is the total interest rate plus the total cost of fees spread throughout a year. When comparing multiple lenders, pay attention to the APR. It will give you a more accurate sense of how much your loan will cost than comparing lenders based on interest rate alone.
Talk with a credit expert
Borrowing capital can help you take advantage of business opportunities. Reach out to a business banker to ask questions and learn more.