Getting a small business loan may sound like a simple task: Fill out some paperwork, get a lump sum of cash and repay it over time with interest. But like any major financial decision, the process requires a bit of planning and preparation, especially if you want to get the best deal.
By taking some time to understand how small business loans work, you can make a more informed decision for your company. Here are three important things to look for when shopping for a business loan — whether it’s a traditional bank loan, a term loan or another type of financing — including the difference between fixed and variable rate loans and how closing costs, interest rates and fees are calculated.
1. Is the interest rate fixed or variable?
As a borrower, you’ll likely have to choose between a fixed-rate and a variable-rate loan. Before making a decision, it’s wise to carefully weigh the pros and cons of each option so you can get the loan that best fits your needs.
With a fixed-rate loan, your interest rate is locked in, which means you’ll have the same monthly payment over the life of the loan. This can make it much easier for future budgeting, since you won’t have to worry about your payments ever changing.
With variable-rate loans, the interest rate can rise or fall because the rate is tied to an underlying index that fluctuates with the market. This means your payments can vary frequently, sometimes as often as once a month, which makes budgeting more difficult. The potential benefit is variable-rate loans generally come with lower initial interest costs, which may entice some borrowers.
A business line of credit is a variable-rate loan that allows you to borrow money and pay it back continuously, like you would a credit card. You pay no interest until you actually draw funds, and you can pay off the balance in full or over time. This type of loan is likely better suited for business owners who don’t need a set amount of money but need access to cash, whether it’s for emergency funds or short-term working capital.
A business term loan provides you with a lump sum of cash at closing. It often comes with a fixed interest rate and is repaid in monthly installments. This type of loan usually requires collateral, which means an asset like equipment or real estate is used as security for repayment of the loan. If you can’t make the payments, you forfeit the asset. For these reasons, this type of loan is better suited for a one-time expense or long-term financing needs, like funding a major business expansion, purchasing real estate or refinancing debt.
A variable-rate line of credit is likely your best bet if you want to save money on interest costs in the beginning stages of the loan, can handle the risk of higher rates and the potential for fluctuations in your monthly payments and only need cash for short-term needs.
But if you need a specific amount of cash for a large business purchase and are uncomfortable with the possibility of your payments changing often, a fixed-rate loan is likely your best bet.
2. What is the annual percentage rate?
The annual percentage rate (APR) determines your total borrowing cost. It includes not just the interest rate, but also all of the associated loan fees like closing costs and origination fees. In other words, the APR is the all-in cost of your loan.
Let’s say you own a chain of fast-food restaurants and you want to take out a $100,000 loan to open a new location. You get approved for a five-year loan, which carries an interest rate of 6%, plus 2% in total fees, giving the loan an APR of 8%. On this loan, you’ll make 60 monthly payments of $2,028 and pay total interest of $21,658 over the repayment period.
What if you shop around and find the same loan at a lower rate? With an APR two percentage points lower at 6%, your monthly payments would drop nearly $100 to $1,933, with total interest costs falling more than $5,000.
The loan rate you receive will depend on a few factors, including your credit history; the profitability of your business and its financial track record; the total amount you borrow; and the length of the repayment period. It’s a good idea to shop around and compare quotes, because some lenders may offer you much lower rates than others.
Ask the lender what fees are included in the APR, why you’ve been given the rate, whether the rate is fixed or variable, and if there are fees or penalties for repaying the loan early.
All of this information should help you make a better-informed decision as you’ll be able to compare the APR with quotes from other lenders and have a full understanding of your loan.
3. What are the loan fees?
Here are some common fees you may face when taking on a small business loan:
- A borrower origination fee, which is an upfront fee that is charged for processing a new loan.
- Underwriting fees that are collected by underwriters who verify and review all of the information you’ve provided. This helps them decide whether or not to provide you with a loan and determines your interest rate. Underwriters generally examine several documents, including financial statements, personal bank statements, credit reports and tax returns.
- Closing costs, which can include other costs associated with servicing the loan such as a loan-packaging fee, a commercial real estate appraisal or a business valuation.
Keep in mind that loans backed by the U.S. Small Business Administration (SBA) 7(a) loan program work a little differently. Loans under $150,000 come with no fees, while loans between $150,000 to $700,000 with a maturity of more than one year cost 3% and loans greater than $700,000 cost 3.5%, according to the SBA.
Each lender should also be able to give you a list of what each fee includes and should explain any fees that you don’t understand. Don’t be afraid to ask questions.
Unfortunately, fees are unavoidable and can add a significant amount of money to your loan. But this doesn’t mean all small business lenders charge the same amount — some may squeeze more dough out of your pocket than others.
Fees are often quoted as a percentage of the total loan and are generally subtracted from the principal. For example, a $1 million loan with 1% in fees would cost $10,000, with the borrower netting $990,000 in principal at closing but still having to pay back $1 million plus interest.
Total fees can range anywhere from 1% to 5% of the amount financed, although the figure varies by lender and will depend on numerous factors, including the size of the business, the total amount financed, the length of the loan term, the creditworthiness of the borrower and the type of institution offering the loan.
Landing a small business loan with attractive terms can be a daunting task. But by educating and preparing yourself, you’ll be in a much better position to succeed.
Small business owner photo via Shutterstock.