Interest rates on business loans

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Are you starting to look at options for business funding? If so then you may be comparing different types of business loans and the costs involved. Assessing the interest rate on business loans is a key part of working out your cost of borrowing.

In this guide we explain everything you need to know about interest rates on business loans. We also answer common questions like “how are interest rates calculated?” and “are interest payments tax deductible?”

Table of Contents

What are interest rates?

Interest rates are set by lenders and are a percentage of a loan that is charged as interest to a borrower. They are often stated as an annual percentage of the loan outstanding. They are part of the charges lenders make to lend money to your business. They help the banks to earn a profit on any money they lend.

The Bank of England base rate affects the cost of borrowing to the lenders themselves. But lenders are free to set their own interest rates at a higher rate than the Bank of England base rate.

How do interest rates work?

Interest rates work in different ways depending on the type of business loan and terms of your agreement. Lenders charge interest on the outstanding loan balance, on a daily or monthly basis, based on your agreed interest rate. For example, if you owe £100,000 and have an agreed annual interest rate of 6% then the interest rate for one month would be 0.5% (6% divided by 12) giving an interest payment of £500. This interest is added to the loan balance and paid off when your repayments are due.

Interest rates on business loans can be fixed or flexible, depending on the terms of your agreement. Fixed interest rates stay the same for an agreed period. This is sometimes the length of the loan but can be a shorter period.

Interest rates on flexible loans change, depending on the lender’s standard variable rate. This standard variable rate is often pegged to the Bank of England base rate. For example, if your loan agreement states that you pay 2% more than the lender’s standard variable rate then your interest rates may change in line with the Bank of England base rate. If the Bank of England puts up the base rate by 0.5% then your lender may decide to raise their standard variable rate by 0.5%, increasing the amount of interest you owe.

What’s the difference between APR and interest rates

When you apply for a loan, lenders usually advertise an annual percentage rate (APR) which gives an indication of all the costs included in the loan.

There are a couple of main differences between interest rates and APR. Firstly, the APR includes interest and other standard fees so it may be higher than the interest on the loan. Secondly, the APR gives an average cost of borrowing. Lenders work out interest rates on an individual basis so you may not be offered this rate if your circumstances are different to the average applicant.

How do banks decide interest rates?

Lenders make their money by charging interest to borrowers. The difference between the amount they charge to lenders and the amount they pay is called the net interest margin. The interest rate banks charge is affected by the Bank of England base rate because this impacts the cost of borrowing to the bank.

However, other factors also affect the interest rates banks will charge. There is always a risk when banks lend money that the lender will default and not repay their debt. Even if the money is eventually recovered there may be significant admin and legal costs.

For shorter-term borrowing and unsecured borrowing there is a greater risk to the bank of default. There is also more risk to the lender if you own a new business without an established track record of repaying debt.

Short term and flexible debt are more complex products and so the lender will incur higher admin costs sorting out your loan.

Lenders factor administration costs and the risk level of default into the interest rates they charge. Any higher costs or greater risk is passed onto customers in the form of higher interest rates.

How is interest on loans calculated?

Interest rates are calculated in different ways depending on your type of loan and the terms of your agreement.

Most loans charge interest on a compound basis rather than a simple basis. This can make a big difference to the overall cost of your loan. Here’s an example to illustrate the difference between compound and simple interest:

  • Business A takes out a loan of £100,000 for 5 years with simple interest of 5% per annum (£5,000) per year. The interest is rolled up and the capital is repaid at the end of the loan period. At the end of the loan period, business A owes an extra £25,000 (5 x £5,000).
  • Business B takes out a loan of £100,000 for 5 years with compound interest of 5% per annum. The interest is rolled up and the capital is repaid at the end of the loan period. At the end of the loan period, business A owes an extra £28,335 (based on compound interest charged each month).

Interest on a loan can be calculated on a monthly or daily basis. Flexible loans like a bank overdrafts or a business credit card are more likely to calculate interest on a daily basis. Daily interest charges will further increase your interest costs if your loan is calculated on an cumulative basis.

What are typical interest rates on business loans?

Interest rates vary considerably between lenders and depending on your personal circumstances, which you can read more about in our study on average business loan interest rates. Here are some typical interest rates for different types of business loans:

How do interest rates affect businesses?

Interest rates affect businesses by adding cost to their borrowing. Choosing the right kind of borrowing and shopping around for reasonable interest rates can help your business cash flow and reduce your expenses.

Are interest payments tax deductible?

Interest payments on business loans that are taken out for business purposes are usually tax deductible, however capital repayments on your loan will not be classed as a business expense.

If your business pays corporation tax, then tax deductible interest is usually restricted to 30% of your UK taxable profits.

Tax rules for individual landlords are complex and you should ask for advice from your accountant.

What business loans have low interest rates?

Longer-term business loans or secured business loans often have lower interest rates. Government-backed start up loans and peer-to-peer loans may also have lower interest rates.

Most lenders charge higher interest rates for flexible and shorter term loans. They may also charge higher interest rates if you are a new business or you have a bad credit record.

How can I find reduced interest rates?

To increase your chances of finding a loan with lower interest rates you should consider the following options:

  • Shop around as interest rates vary considerably.
  • Consider cheaper forms of borrowing like peer-to-peer lending, a government start up loan or a simple term loan.
  • Think about applying for a secured loan or offering personal guarantee to reduce your interest rate.
  • Prepare a robust business plan if your lender requires one.
  • Look for ways to improve your credit rating, if this is an issue.

What else should I consider apart from interest rates

Don’t forget to look at other business loan costs apart from interest rates. Bank fees and any professional fees can add up over time and will add to your total cost of borrowing.

Apart from interest rates, here are some other things to consider when you apply for a business loan:

  • Bank fees including arrangement fee, annual fee and early repayment charges
  • Any professional fees incurred as part of the application process
  • Admin cost and time of managing the loan
  • Flexibility of the loan. A flexible loan may be more expensive in the short loan but cheaper in the long run if you pay it off early.
  • Ability to borrow more in the future
  • Risk of securing assets
  • Risk of taking out a personal guarantee

Frequently asked questions

Rolling up interest can be a great help if you are funding a new project. You may not have cash flow available to make initial loan repayments.

However rolling up interest will also add to the cost of your borrowing. This is because most lenders charge interest on a cumulative basis, so not paying off the loan will add to your interest payable and your total cost of borrowing.

Lenders often charge higher interest rates to businesses with bad credit. This is because there is a bigger risk for the lender that you will default on your loan repayments. It may be possible to find a more reasonable interest rate if you offer a personal guarantee or assets for security.

The Bank of England base rate affects the cost of borrowing for lenders. They will usually adjust their interest rates on flexible loans when the Bank of England base rate changes.

If you have a fixed rate loan then any change in interest rates won’t affect your loan repayments, until your fixed period ends. If you have a flexible loan then your interest rates may change.

Businesses often pay slightly higher interest rates than consumers. This is for several reasons:

  • Lending to businesses is more often more risky than lending to consumers as there is a risk that the business will become insolvent and any debts won't be repaid.
  • Businesses often require more flexible lending than consumers and this results in higher admin costs for the lender.
  • Lenders often offer extra services to businesses like relationship managers who you can talk to directly about your financial needs.