Businesses need capital in order to keep their doors open, and sometimes that capital comes in the form of a small business loan. It’s important to understand the terms of the loan before you take out a loan, which can be confusing to understand when reading through pages of banking jargon and loan terms.
When evaluating the cost of a business loan, you will likely come across two important terms; the interest rate and the annual percentage rate (APR). Let’s take a look at how these affect your loan.
What is Interest Rate?
The interest rate is typically what’s advertised to the consumer, also known as a nominal interest rate or interest expense. This interest rate is what the borrower pays each year to borrow the funds, less any fees or charges to accept the loan.
If a business owner takes out a micro-loan of $50,000 with an interest rate of 8%, for example, the interest expense would be $4,000, or a monthly payment of $333.33.
Loans can also come as a fixed or variable interest rate. A fixed interest rate will never change during the life of the loan, while a variable interest rate will vary with market fluctuations. Variable interest rates can be helpful if the index declines; however, if it rises, the borrower has to pay more than when they originally accepted the loan. If you are unsatisfied with the interest rate offered to you, you may be able to receive a better rate by rate shopping or, if your situation allows, work on building your business credit over the next year so you aren’t considered a high-risk borrower.
What is Annual Percentage Rate?
The APR of a loan is expressed as a percentage and includes the interest expense and all fees and costs involved with loan procurement. The APR is the more effective rate to consider between the two because it includes all fees and costs with the loan procurement.
For example, if that same business owner takes out a $50,000 loan that comes with $4,000 in added fees and charges, they now have a new loan amount of $54,000. Take 8% of $54,000 and the new annual payment is $4,320, or a monthly payment of $360. The APR is typically the same or higher than the interest rate except in special instances, like when a lender offers a rebate or waives certain fees.
Maintain Good Credit
In order to get the best rate available, you’ll want to have good-excellent personal credit and good-excellent business credit. Banks run a credit check against the actual business owner by looking at their personal credit score in order to determine their creditworthiness. Some find this methodology to be ineffective because a borrower could have excellent credit with a business that’s losing money, or poor credit with a highly profitable business. That’s why it can be helpful to maintain a credit score for your business.
Just like with personal credit, you won’t have a credit score until you actually start borrowing against the business. There are a few ways you can build business credit:
1. Open a business bank account. You will need to register for a DBA (“doing business as”) and will need a tax ID number in order to set up a business banking account.
2. Get a DUNS number. Applying for a Dun & Bradstreet number takes about a month, so you’ll want to plan ahead.
3. Buy from vendors that report to credit agencies. Reporting your business credit to the appropriate credit bureaus is done on a voluntary basis, so make sure you’re working with those that will report your credit activity.
If you aren’t sure if you have a business credit score yet, sign up at Nav.com.
When considering your loan options, do your research to find the best possible option for your needs. Other important fees and charges you should look out for include:
- Origination fees
- Administrative fees
- Application fees
- Monthly maintenance fees
- Underwriting fees
- Closing costs
If you can, seek council with an unbiased lending specialist about your options, including any fees and charges. It’s best to avoid speaking with a loan broker as they may suggest a loan that’s more beneficial for them (higher commissions) instead of you, the borrower.