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# What You Need to Know About Loan Interest Rates

Need to borrow money? How can you qualify for lower interest rates? How do you maximize profits? What is your debt to income ratio? These are common questions that business owners ask when looking into small business loans.

## Types of Loan Interest

The intricacies for all the different loan options, business loan interest rates and how they all work is vast. Even the smallest details can make a big difference on your loan payment, interest costs, monthly payment, extra payments, loan amount and more . So however intimidating, knowing the different loan types will better prepare you for understanding the needs of your specific small business, and help you get a lower interest rate.

### Fixed Interest

A fixed interest rate neither increases nor decreases over time; it is a pre-set amount that doesn’t change, no matter the circumstances.  It's a predetermined, fixed rate tied to a loan or a line of credit that must be repaid, along with the principal amount. A fixed-rate is the most common form of interest for borrowers. Such rates are easy to calculate and understand and are less volatile overall. Both the borrower and lender will always know exactly what the loan interest rate will be because it will not change.

For example, consider a loan of \$20,000 from a bank to a borrower. Given a fixed interest rate of 6%, the actual cost of the loan, with principal and interest combined, is \$21,200.

### Variable interest

Opposite from fixed rates, a variable rate (sometimes called an “adjustable” or a “floating” rate) can fluctuate.

Variable interest is usually based on an underlying benchmark interest rate or index that changes periodically. For example lenders can use "prime interest rate" to set their interest rates on. In some cases, the borrower can benefit from variable loan rates due to the fact that if the underlying interest rate or index declines, so too do the borrower’s interest payment amounts.

In conjunction, if base interest rates were to rise, then the borrower may be forced to pay more interest - as loan interest rates rise when they're tied to the prime interest rate.

### Simple interest

Simple interest is a quick and straightforward process used to determine the interest rate on a loan. It is determined by multiplying the daily interest rate by the principal by the number of days that elapse between payments.

Simple interest = Principal x Interest Rate x Time

### Compound interest

Compound interest refers to the loan’s interest amount that is calculated based on both the initial principal and the accumulated interest from previous periods. Compound interest can be considered "interest on interest," - this makes a financial amount grow at an accelerated rate versus simple interest, which is only increased on the principal amount.

The formula to find your compound interest is:

= P [(1 + i)n – 1]

Where P stands for principal, i stands for the nominal annual interest rate as a percentage, and n represents the number of compounding periods.

Take a loan of \$100 at an interest rate of 5% that compounds annually. What would be the amount of interest? In this case, it would be:

\$100[(1 + 0.05)2 – 1] = \$100 [ 1.1025– 1] = \$10.25

\$100[(1 + 0.05)3 – 1] = \$100 [1.157625 – 1] = \$15.7625

So, at the end of the second year you will need to pay back \$110.25 (the interest being \$10.25) and at the end of the third year you will need to pay back \$115.76 (the interest being \$15.76).

### Annual percentage rate (APR)

This is the yearly rate charged for a loan (it could also be used to show how much will be earned by an investment), and is expressed as an interest rate. APR is shown as a percentage that represents the actual yearly cost of funds over the term of a loan. The annual percentage rate determines the percentage of principal you will pay every year by looking at loan terms and monthly payment rates.

Unlike an interest rate, it includes other charges or fees such as mortgage insurance, most closing costs, discount points, late fees, loan origination fees, and any other administrative fees.

To calculate the APR of a loan, you need to take into consideration the principal amount, the number of years the loan will last and the extra charges that the loan incurs in addition to interest. Here is the APR formula:

To calculate APR, use the following steps:

1. Calculate the interest rate
3. Divide this by loan amount (principal)
4. Divide this by the number of days covering the loan term
5. Multiply all by 365 (one year)
6. Multiply by 100 to convert to a percentage

APR = ((Interest + Fees / Loan amount) / Number of days in loan term)) x 365 x 100

## What is the Current Interest Rate for Small Business Loans?

According to Statista, the interest rate for business loans in Canada fell drastically over the early months of 2020. In the beginning of February 2020, the interest rate for business loans was 4.02 percent, only one month later - the start of March 2020 - the rate dropped down to 3.29%. Though not as dramatic as between February and March, the interest rate has continued to decrease and was 2.82% at the start of August 2021.

## What Affects My Interest Rate?

There are a multitude of factors that will determine how much interest you will pay. So if you want a lower interest rate you will need to do your research.

### Personal and business credit score

Having a good credit score will protect you from a higher interest rate, and is based on your credit report along with your credit history. A credit score is a measure used by financial institutions or lenders to determine your trustworthiness when it comes to paying off money owed. I will be represented as a three digit number (300 - 900) which will indicate how risky it would be for a lender to loan you money. If you have a higher credit score, this could result in lower interest rates on your loans because the lender will see you as less of a risk.

It is important to note that your business credit must be separate from your personal credit. Once you have a separate business account, you can start building business credit.

Personal credit is based on your personal financial history and demonstrates how reliable you are with your personal finances. In comparison, business credit is directly tied to your business’s financial history. It will demonstrate whether your business is a good candidate to lend money to or do business with. This will be an indication to lenders, suppliers, and other vendors how likely you are to pay your business-related invoices and bills on time.

### Annual turnover

Annual turnover is the percentage rate at which something changes ownership over the course of a year. For a business, this rate could be related to its yearly turnover in inventories, receivables, payables, or assets.

Businesses look at annual turnover rates to determine their efficiency and productivity while investment managers and investors use turnover rate to understand the activity of a portfolio. Annualized turnover is often a future projection based on one month—or another shorter period of time—of investment turnover.

### Loan type

All loans are not created equal. The type of loan you choose will have a direct impact on the interest rate you end up paying. Here are examples of a few different types of loans:

• Mortgage Loans
• Short Term Loans
• Secured Loans
• Unsecured Loans
• Personal Loan.
• Home Loan.
• Gold Loan.
• Rental Deposit Loan.
• Loan Against Property.
• Personal Loan for Self-Employed.
• (Other loans)

### Loan security

When it comes to loan securities, lenders can ask the borrower for security or collateral, which is an asset the borrower must pledge to the lender in the case that they cannot repay the loan.

Essentially, collateral helps to protect the lender should the borrower default on their repayment obligations. Should this happen, under the loan agreement, the lender is legally allowed to take ownership over the pledged asset in place of repayment. At the same time, the lender has the right to sell the asset to ensure repayment of the outstanding loan, plus the interest incurred. Any proceeds left over after repayment is assured will go back to the borrower. Therefore, the asset must be as valuable as the outstanding loan amount to ensure proper recompense.

### Current and projected finances

Similar to creating a budget, financial projections are a way to forecast future revenue and expenses for your business. A current income statement, balance sheet and cash flow statement, will be needed to make future financial projections.

### Supply and demand

Increases in the amount of money available to borrowers raises the supply of credit. For instance, when you open a bank account, you are lending money to the bank. Therefore, depending on the kind of account you open, the bank has the right to use that money for other investment and business activities. Simply put, the bank can lend out your money to other customers. The more banks lend out, the more significant the credit is available to the economy. By extension, as the supply of credit increases, the price of borrowing (interest) decreases.

On the other hand, credit available to the economy decreases as lenders decide to postpone repayment of their loans. For example, when you choose to defer paying this month's credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market. This, in turn, will increase the interest rates in the economy.

## Terms and Interest Rates Defined

There is a significant amount of fine print when it comes to taking out loans, so it is important you familiarize yourself with commonly used and misunderstood terms to ensure you are getting what you bargained for.

### Principal

Principal, in the financial world, has a few different definitions. However, in terms of loans, the term principal refers to the original sum of money borrowed from a lender. In addition, it can also refer to the outstanding amount of the loan still owed. For example, if you take out a \$70,000 mortgage, the principal is \$70,000. Should you pay off \$40,000, the principal balance becomes the remaining \$30,000.

The principal amount is used to calculate the amount of interest you need to pay on your loan. For example if your loan has a principal amount of \$20, 000 and an annual interest rate of 10%, you will have to pay \$2000.

### Loan term

The terms and conditions a borrower is obligated to when taking a loan from a lender, is referred to as “loan terms” - vice versa, the lender must also honour the agreed upon conditions. Loan term encompasses all the details made in the arrangement between the borrower and lender. These conditions can include:

• Interest rate
• Total interest
• Total cost
• Monthly payment
• Fees associated with the loan
• Loan repayment period
• Penalties
• Any other conditions that may apply

### Down payment

A down payment is a portion, or percentage, of a greater sum of money that a buyer is required to pay upfront in the early stages of a transaction. The down payment represents a percentage of the total cost of the item/service, and must be paid before the loan is received.

Once the down payment has been paid, the buyer can take out a loan to cover the remaining balance. For example, if a home costs \$1 000 000, and the buyer pays a down payment of \$200,000, the buyer can get a mortgage for the remaining \$800, 000.

The more money put towards the down payment, the less money is needed for the buyer to complete the transaction (therefore a smaller loan balance), the lower their monthly payment, and the less they'll pay in interest over the long term.

### Personal guarantee

A personal guarantee is a written legal promise from a business owner or individual to repay credit issued in case of default for interest paid, therefore adding extra protection for the lender.

The business owner offers their own assets and promises to repay a debt from personal capital in case the company defaults. Basically, the business owner becomes a cosigner on the credit application.

Personal guarantees are normally used by small businesses or by those who do not meet credit history requirements.

### Interest

Interest is the amount of money a financial institution or lender charges and profits from when they lend out funds. From the borrower perspective, interest is the cost of borrowing money, normally expressed as a percentage.

At the same time, interest can also refer to the percentage of ownership a stockholder has in a company.

### Interest rate and annual percentage rate (APR)

Interest rates and APR are commonly used interchangeably, however, this is a mistake. While they are similar concepts, they do have some subtle differences.

Interest rate covers the percentage a lender charges to borrow a principal sum. An annual percentage rate is higher than the interest rate because it includes the all costs associated with the loan. The APR can include fees such as: broker fees, closing costs, rebates, discount points etc.

While the interest rate determines the overall cost of borrowing the principal amount, the APR is a more accurate picture of total borrowing cost because it takes into consideration other costs associated with obtaining a loan.

### Prime rate

Prime rate is one of the largest benchmarks, or starting points, used when determining the percentage of interest on a loan (such as mortgages, small business loans, or personal loans) and every bank sets their own prime rate. Banks charge prime rate to their most creditworthy (prime) customers  who have very low risk of default. (Prime rate is normally a lower interest rate on a higher loan amount).

The prime rate in Canada is largely based on the policy interest rate set by the Bank of Canada (BoC), which is the overnight rate that banks use to lend to one another.

A traditional lender could be a big commercial bank or a credit union. Traditional banks can not only offer lower APRs  on loans but generally have a more extensive range of financial services and products to choose from. Their long histories also mean that they have a wealth of experience to draw from. This means that anyone with an exceptional credit score or any business with a few years under its belt should at least consider it as an option.

However, traditional banks also have much higher application standards and lower approval rates. They also can’t move as fast as their nimble challenger alternatives, so you generally won’t get your money as fast.

### Alternative lenders

Other lenders or alternative lenders are typically online based, private companies. For younger businesses (or younger people in general) using an alternative lender for a loan is typically going to be the better option. This is because the application requirements are far more forgiving but you will also get your money faster. The only real drawbacks are the higher APR (therefore possibly resulting in higher monthly payments and interest fees)  and the fact that they are less proven entities than their traditional counterpart.

### Debt covenants

Debt covenants cover the restrictions that lenders, such as creditors, debt holders, and investors, place on loans or other types of debt agreements to limit the actions of the borrower. In other words, a debt covenant is a deal between a borrower that can limit the borrower from performing certain business activities. This can protect the lender from risks that they did not consider when calculating the overall risk level of the borrower and loan amount.

For example, if a bakery shop owner requests a loan from a lender, the covenant can dictate that the bake shop owner will not be allowed to start producing anything other than his baked goods - like surfboards, or cell phones.

Managing your business’s financial situation is crucial for staying on top of loan payments and interest costs. With QuickBooks Online you can track revenue and expenses as well as receive reports on your payment history so you can easily gather the credentials you need to apply for loans, as well ensure you can make those monthly payments. Try it today.