Loans are often utilized in small business to jump-start or run a business. Therefore, it’s important to understand interest rates and how they effect your loan. This article will teach you all the important information you need about loans. Read it today!
More often than not, business owners need to apply for loans in order to jump-start or run their businesses. Since loans are never free, interest rates are attached to these loans, and there are several types of loans that have varying interest rate designs and percentages. However, it is important that a business owner understands how interest rates are established, how to borrow funds, and how to negotiate the most competitive interest rates.
Interest refers to how much it will cost an individual to borrow money. It is imperative for a business owner to understand the economic forces that impact interest rates. Interest rates are determined by the Federal Reserve, usury laws, demand for US Treasury notes and bonds, and the banking industry. From a macroeconomic perspective, interest rates are influenced by the overall health of the economy. They take into account GDP, stock market numbers and unemployment rates. Interest rates increase mainly due to inflation. Investors want to preserve their purchasing power, so if inflation is high and the risk to spend is higher, they will need a higher interest rate to consider lending their money for more than the shortest of terms.
At the top federal level, the Federal Reserve Chair will formally announce when interest rates will rise, and this increase is called a rate hike. It is important for businesses to be aware of rate hikes, so they can respond and apply for a loan or line of credit prior to when the rate hikes take place. The rise in interest rates also results in a rise in the Prime Rate, which refers to the credit rate that banks will approve for their customers with the strongest credit and the lowest risk. Banks use the Prime Rate as a baseline to determine interest rates across all borrowers.
In addition to the Federal influences on interest rates, individual states legally set limits on maximum interest rates. These are called legal rates and are governed by usury laws. Usury rates are the highest interest rates, and these loans can be considered predatory. An example of a usury rate is a payday loan, which has an extremely high interest rate and may also have hidden provisions that charge borrowers added fees. It would not be in the best interest of a business owner to look at these types of loans.
Another factor that influences interest rates are the length of the interest rates. Long term interest rates are typically higher than short term interest rates, since there is added risk of committing capital for a longer period of time. The Federal Reserve directly determines short term interest rates, while demand for US Treasury notes and Bonds directly affects long term interest rates.
The banking industry also affects interest rates. In the housing industry, for example, banks created variable interest rate loans, and banks determined the interest rate levels and when they changed. Another classic example are credit card interest rates, which can be quite high and are determined by the individual bank. When an individual misses a credit card payment, their credit card interest rate can rise significantly, since the risk the bank is committing to is now higher as well.
A business owner has several resources available to them when it comes to considering how to borrow funds. This article will cover just a few of these options, including Small Business Association Loans, Fixed-Rate Bonds, and adding lines of credit.
The Small Business Administration (SBA) is an independent government agency that supports small businesses by issuing loans and providing services like contracts and counseling. They also dictate interest rate ranges that are permitted when lender banks issue SBA loans to businesses. Some loans are restricted in terms of how the funds are used as well.
There are three types of SBA loans:
SBA 7A loans and SBA Express loans can be used for a wide variety of purposes. CDC/504 loans, however, can only be used to purchase fixed assets like real estate and heavy machinery. Generally speaking, the larger the loan, the lower the interest rate. There are several calculators online that help determine what a business owner may expect to pay for a loan by plugging in basic information like the loan amount, their credit score and the repayment time period.
In order to qualify for these loans, a business typically needs to meet the following guidelines:
In addition to SBA loans, there are other fixed rate and variable interest loan options available to business owners.
Fixed rate bonds are loans that allow a business to gain investors while remaining privately owned. A small business can set up the bonds to have a fixed interest rate, so investors are aware of exactly how much they will receive and when. Business owners are responsible for making regular interest payments to their bond owners until the bond matures. When the bond matures, the business owner is responsible for paying off the entirety of the bond plus interest.
However, as time goes on, and a business owner continues to issue fixed-rate bonds, the interest rate on the bond could increase if the Federal Reserve announces a rate hike. Interest rates and bonds are inversely related: when interest rates go up, the value of the bonds go down. For example, someone who bought a fixed-rate bond at 4.5% in 2015 might want to purchase the same bond in 2018 at 6.5%. If they sell the 4.5% bond in a higher interest rate market, they lose money. The opposite can also occur; if interest rates decrease from 4.5% to 3.5%, the investor makes money. Either way, a business owner needs to be aware that interest rates on bonds can increase based on market conditions and be prepared for it.
A business also has the option to apply for a line of credit through their banking institution(s). This is essentially a credit card, where a business can pay for goods and services to run their business, and they will have to pay back the amount charged along with interest. When a bank looks at a business’s application for a line of credit, they will look specifically at their credit history and credit score to determine how much risk they will carry, and therefore what the interest rate for borrowing funds will be.
Credit or FICO scores are the way lenders determine how much risk a borrower carries when taking out a loan or taking on another line of credit. The higher one’s credit score, the less risk there is for a lender. There are three main credit bureaus that lenders utilize when looking at a borrower’s credit: Equifax, TransUnion and Experian. Each credit bureau looks at a borrower’s credit history and determines their FICO score. FICO refers to the data analytics company Fair, Isaac and Company, and its score has become the main credit score that commercial lenders use to determine whether or not to approve a loan. Higher FICO scores also can allow a borrower to negotiate a lower interest rate as well.
For business owners who do not have a solid FICO score, there are several ways to improve their scores to try to negotiate a better interest rate. The top three ways to improve credit include:
If a business owner’s credit is still not high enough to secure a loan, a cosigner may be a viable option. A cosigner is someone who joins the primary borrower in taking on the responsibility for a loan and attaches their credit to a loan. This helps the primary borrower acquire a lower interest rate. There is risk attached to having a cosigner, however. If the business owner is unable to make payments for any reason, their credit is negatively impacted. The positive, on the other hand, is that if a certain amount of the loan is paid back in a timely manner and the business owner’s credit score has improved, they can release the consigner from the loan.
Despite all of these factors, interest rates can still be influenced by a business owner with their lender. A few factors to help negotiate or research interest rates on a loan include:
If a business owner has negotiated and researched different options and determines that it might be best to transfer their account to obtain a lower interest rate, there are pros and cons that need to be considered. Should they wish to transfer their account to a different lender, there are several factors to be aware of:
However, there are several positives that may make transferring a credit card account worth the change:
Once a business owner calculates their best option, they can determine if transferring their account is the best route to take.
All in all, there are many external economic influences that affect interest rates, but a business owner should still understand what actions they can take in order to negotiate the best rates. It is important to know various funding options like loans, bonds or adding lines of credit. Taking steps to improve one’s credit score, researching lending options, and transferring an account can positively impact a business’s financial situation. Interest rates can be complicated, but conducting the right research and making informed decisions will help a business owner succeed.