What Is an Interest Rate?
An interest rate is the percentage charged by a lender to a borrower for lending a sum of money. This rate is quoted as a percentage of the amount of money you borrow (known as the “principal”). Based on the interest rate you are quoted, you will pay back a portion of your loan plus interest and other fees in accordance with your repayment schedule. Different types of interest rates include adjustable interest, simple interest, compound interest, and factor rate.
There’s a famous saying that goes, “There’s no such thing as a free lunch.” This adage refers to the idea that it is impossible to get something for nothing. When applied to the world of small business—specifically small business finance—it means that there’s no such thing as free money. Case in point, you’ll always have to pay a fee if you take out a small business loan. In most situations this fee is expressed as an interest rate.
You’re likely already familiar with the concept of interest rates. They have applications across the world of consumer and business lending. For instance, you pay interest on your mortgage, student loans, and overdue credit card balances. But if you’re looking into taking out a loan for your small business, it’s important to establish an in-depth understanding of interest rates—lest you get saddled with a loan product that ultimately hurts your business more than it helps.
So in this guide we’re going to explain everything you need to know about interest rates, including how they work and all the different types of interest rates you need to know before you take out a loan. We’ll even provide you with some interest rate examples to help you apply what you’ve learned.
Let’s get started.
What Is an Interest Rate?
When it comes to small business lending, an interest rate is the percentage a lender charges a borrower (you) to borrow a sum of money. This interest rate is quoted as a percentage of the amount of money you borrow (known as the “principal”). As the borrower, the amount you pay in interest is the cost of debt. For the lender, the interest rate is considered the rate of return.
Keep in mind that the interest rate only includes the interest percentage you will be charged for borrowing the money, and it does not include any other fees you might be required to pay on the loan—such as origination fees, closing fees, documentation fees, and other finance charges.
How Do Interest Rates Work?
As previously stated, the interest rate is quoted as a percentage of the principal. Based on the interest rate you are quoted, you will pay back a portion of your loan plus interest and other fees in accordance with your repayment schedule. Now that we understand the interest rate definition, let’s explore the different types of interest. There are a few different types of interest rates, and to understand how interest rates work, you need to understand each of them individually.
Fixed Interest Rate
As the name implies, with fixed interest rates, the interest rate you are quoted when you take out your loan remains the same throughout the life of the loan. Fixed interest rates are common amongst alternative lenders, including many of the lenders on the Fundera platform.
Within the category of fixed interest rate loans, there are several different types of interest rates. Let’s have a closer look at all three:
What Is Simple Interest?
The simple interest rate, also called the nominal interest rate, is the interest you’ll pay the lender in addition to the principal. That additional fee is how lenders make money off their loans. It’s expressed as a fixed percentage of that principal amount.
Here’s the simple interest rate formula:
Simple interest = Principal x Interest rate x Duration of loan (years)
Let’s see simple interest in action:
Let’s say you take out a $10,000 loan with a 10% simple interest rate. The term of your loan is two years, and the repayment schedule is monthly. What’s more, there are no additional fees associated with this loan.
In order to figure out how much you are going to pay each month, first figure out your cost of debt. To do so, multiply the interest rate by the principal ($10,000 x 10%). The result is $1,000. Next, you’ll multiply the $1,000 by two, since the duration of the loan is two years. The result is $2,000. This means you will have to pay back the original loan amount ($10,000), plus an additional $2,000 in interest, for a total of $12,000.
To get your monthly payment, divide that $12,000 by 24 (because there are 24 months in 2 years). This shows us that your monthly payment on your loan is $500.
What Is Factor Rate?
Factor rates are simple interest rates expressed as a decimal figure. They usually range between 1.1 and 1.5. To calculate how much you’ll owe in total, simply multiply the factor rate by the amount borrowed. For example, if you borrow $10,000 at a factor rate of 1.25 for a six-month term, the total amount you’ll need to repay is $12,500 ($10,000 x 1.25 = $12,500).
Note that factor rates are used specifically for short-term loans with daily or weekly payments, and when a factor rate is involved, all of the interest is charged to the principal when the loan or advance is originated.
What Is Compound Interest?
Compound interest, or interest on interest, is when lenders charge interest on the initial principal plus on any accumulated interest. Loans can compound daily, weekly, monthly, or annually. Here’s the basic compound interest rate formula:
- Principal x Interest rate = Interest for first payment
- (Principal + Interest earned) x Interest Rate = Interest for second payment
- (Principal + Interest earned) x Interest Rate = Interest for third payment
This formula continues for the number of payments that you have. With compound interest, you’ll undoubtedly end up paying a higher cost of debt than you would with a simple interest rate.
Adjustable Interest Rate
On the other side of fixed interest rate is adjustable interest rate. Adjustable interest rates are primarily used for bank loans and SBA loans. These are interest rates that can fluctuate during the life of the loan based on the market Prime Rate. The Prime Rate is the interest rate that commercial banks charge their most creditworthy customers. The federal funds rate—which is the rate that banks use to lend to one another—determines where the market Prime Rate falls.
If you’re applying for a bank loan or SBA loan, know that these lenders will use the market Prime Rate as a starting point for setting your interest rate. As the market Prime Rate fluctuates, the interest rate you pay on your loan changes as well. This means your interest rate can be different from month to month. Also note that the riskier you are as a borrower, the further away you will be from the market Prime Rate (more on this later). As of this writing, the market Prime Rate is 5%, per the Wall Street Journal.
While adjustable interest rates may, in some cases, start off lower than fixed interest rates, keep in mind that the rate can always increase. Before you take out a loan with an adjustable interest rate, make sure you’re in the financial position to continue making your payments in the event that the interest rate jumps.
Annual Percentage Rate (APR)
You can’t talk about interest rates without talking about APR, or annual percentage rate. The difference between APR and interest rates is that APR provides a more comprehensive look at how much you’ll pay when you take out a loan by factoring in interest rate along with any fees you pay for borrowing (origination fee, application fee, closing fee, etc.). APRs also take into account the repayment term of your loan. Basically, it’s the total price of borrowing money expressed in terms of an interest rate.
If you’re comparing two different loan offers, you must convert their associated fees into APR to truly understand which option is better. In many cases, your lender will provide you with the APR when you apply for a loan. But in some cases, you’ll just be given an interest rate. And if you only have an interest rate but know that you’re paying more in fees, then you should get a sense of what your APR will be.
To calculate APR, here’s what you need to know:
- The interest rate of the loan
- The total amount you plan to borrow
- The repayment terms
- The cost of any fees
The simplest way for you to calculate APR on any loan is to use a loan calculator or a spreadsheet. For instance, in Google Spreadsheets, you can calculate the monthly payment and closing costs for the scenario described above with built-in formulas.
How Are Interest Rates Set?
Both fixed and adjustable interest rates take into consideration a wide variety of factors when determining the cost of capital—the only difference being that adjustable interest rates also consider the market Prime Rate.
The interest rate quote is determined by a loan underwriter, or someone who sets a loan’s terms by assessing the borrowers ability to repay the loan. When determining your interest rate, the loan underwriter will consider the type of loan product, your business or personal credit score, your time in business, your business’s revenue and profitability, as well as other factors.
Generally speaking, businesses with good credit scores, a long history of success, and strong financials will get more generous interest rates, as they are considered “low risk” by the lender. On the other hand, if you’re a new business, are struggling financially, or have a bad credit score, you are considered a “high-risk” borrower, and will be quoted a higher interest rate.
What Is a High Interest Rate?
So, if you are a “high-risk” borrower, how much will your interest rate be? Well, this can vary widely depending on the lender, type of loan product, term of your loan, specific financials of your business, and a wide range of other factors. Some bank loans have interest rates as low as 3%, while some alternative lenders can charge interest rates as high as 150%.
In order to understand what might be considered a high interest rate, let’s look at what the average interest rates are for a variety of different loan types. These are the interest rates charged by lenders for loan products on the Fundera platform, expressed as APR:
- Traditional bank loans: 3% to 6%
- SBA loans: 7.5% to 10%
- Medium-term loans: 7% to 30%
- Equipment financing: 8% to 30%
- Business lines of credit: 7% to 36%
- Invoice financing: 13% to 60%
- Short-term loans: 8.5% to 80%
- Merchant cash advances: 40% to 150%
In order to determine if the interest rate you’ve been quoted is high, compare it to these average rates. Just keep in mind that if you are a high-risk borrower, it will be harder to be quoted an interest rate in this range.
Finding the Right Interest Rate for Your Business
Now that you have a well-rounded understanding of interest rates, you’re probably wondering how to figure out if the interest rate you’ve been quoted on your loan is ultimately going to help or hurt your business.
When considering the cost of capital, Sarah Hoskin, a senior loan specialist at Fundera, recommends evaluating whether the juice is truly worth the squeeze:
“Don’t say yes to any loan immediately,” Hoskin says. “Determine if what you are going to use the money for will net you more than what it will cost you to take out the loan. For example, if you need $100,000 for inventory and it will cost you $115,000, but you determine you will make $130,000 off of the new inventory, then the loan is worth it.”
Another tip Hoskin tells her customers is to not overreact to an interest rate:
“You’d be surprised how close in cost a 15% interest rate and a 20% interest rate is,” Hoskin explains. “The difference between the two may be alarming at first glance, but in reality it can be as little as $60 per week. People often come to the table with high expectations of the rates they think they deserve, but if they get quoted a number higher than they expected, they should still think it over closely. More times than not, taking the loan would still make sense.”
So there you have it. Now you have an interest rate definition, know how interest rates work, and are equipped with the tools to determine if a quoted interest rate is right for you. Armed with this knowledge, you’re ready to enter the loan market and find a loan option that will help your business achieve its goals.