Factors Affecting Interest On Business Loans

A household or an individual needs credit to fulfill some of their needs and purchase certain high-value assets. What holds good for an individual holds good for an enterprise or a business too. A business needs finance for both short term and long term growth. The funds needed for running the business may come from various avenues like promoter's own funds, venture capitalist, angel investors, from public funding or from loans, etc.

Very often, business loans come across as a go-to method for financing needs of a business due to many factors like:

• Availability for a shorter duration

• No need to give up stake unlike equity

• Interest paid on loan is tax deductible

• Interest payments or EMIs are known in advance, helping the business plan its finances better

• This option works well even for smaller companies

However, one of the important factor that decides if the business should or should not go in for a business loan is the interest charged on the business loan. Through this article of ours, we try to make you familiar with the factors that affect a business loan, as it is important for any business to be aware of the factors so that they can accordingly plan to avail a business loan for their need.

Factors Influencing The Rate Of Interest on a Business Loan

• Credit Worthiness of the Business: Creditworthiness of a business as measured by its credit score or credit rating is one of the primary factors that affect the interest loan on a business loan. Lending is a risky affair for any lender and the only way they can ensure that they lend to a creditworthy business is by checking their business credit score. If the business is small or doesn't have a credit history of its own, then it is the personal score of the promoter/ founder which is taken into account. A good credit score will give the borrower a good edge to obtain loans on competitive rates of interest.  

Additional Reading: Learn how personal credit scores can affect business loans 

• The Business Financials: Any lender would not like to lend to a borrower without sound business fundamentals. Therefore, a business which has sound business financials will make a potential candidate for a loan as they can be assured of repayments without any problem. A good profit making business may also land lower rates of interest due to lower risk involved in lending. This is also important to gauge if the proposed amount of loan can be repaid by the borrower. 

• Time in Business: Lenders like to lend to businesses that have proven themselves over a period of time, rather than a newbie.  Well established businesses will have a track record of dealing with credit and also through the business environment, which gives lenders a sense of security while lending with lower interest rates. Hence start-ups may face tough times securing finance from traditional lenders like banks and other financial institutions.  

• Collaterals: Very often business loan are lent against collaterals. If a business can provide sufficient collateral to the lender against the loan, then the interest charged on such a loan may be lower as the collateral lowers the risk of the lender in lending. Again, a new/ small/ service related business may find it difficult to provide collaterals need for securing a business loan. Going with the same logic, unsecured loans may run a higher rate of interest.  

• Type of Business: Each business has a different business model. While some may be production oriented, some are service oriented. Some businesses also carry a higher risk due to various factors. So depending on risk perception of the business by the lender, the interest rate charged on the business loan may differ. 

• Future Growth Prospects: A loan is generally availed to better the prospects of the business. If the business shows great prospects of growth through its business plans, a lender may base the interest rate at a lower level. This would also depend on the business plan and the ability of the promoter to successfully steer the business towards growth.  All these factors together form the basis on which the business interest rates are structured.  

Additional Reading: 5 steps to take if you have been denied a business loan 

External Factors that Affect the Interest Rate on Business Loans 

Business loans are affected by many other external factors too that are not within the control of the business. These may depend on the general economic conditions of the country and other factors. This is true of all loans, and not just business loans in particular. Some of the factors are 

• Monetary Policy of the Country: Monetary Policy in India is decided by its Central Bank, the Reserve Bank of India. RBI uses many tools to adjust the amount of money supply in the market and each of them have a bearing on the amount of money in circulation. If the liquidity is adequate, then the interest rates on loans are lower and vice versa.  

• Inflation: As per definition, inflation is the measure of the rate at which the price level of a certain basket of selected goods and services increases over a period of time. The level of inflation in the economy plays a role in determining the interest rate in the economy. When the inflation in the economy goes higher, things turn costlier and hence, there is decrease in purchasing power of the individuals. In such a scenario, the interest rates go up. Inflation is also one of the factors that has a bearing on RBI's monetary policy too.  

• General Turn of Events in the Economy: There are many players in the economy, like banks, financial institutions, companies, stock markets, lenders in the unorganized market, borrowers (both retail and business), etc.  All these players are inter-connected, hence any untoward incident in one sector has a ripple effect on the other players. For Ex: The recent fiasco of IL&FS saw liquidity drying up in the market which sent interest rates higher.