Four Questions on Business Loan Interest Rates Answered


Most small businesses, at one point in time or another, have to take out a business loan to function. This could be a working capital loan, machinery loan, loan against property or any other form of credit for their short-term or long-term needs. All borrowing comes at a cost, usually paid in the form of interest. Here are four things you need to know about interest paid on a business loan:

1. What is interest rate?

Interest rate is the cost of borrowing money. It is the amount that a lender charges to the borrower for a loan. Usually, it is computed as a percentage of the principal loan amount per annum, or a period of a year. When a borrower repays the amount borrowed, they repay the principal plus the interest.

An important aspect to note here is that though the interest rate is the largest part of the cost of borrowing, it is not the only charge to consider. Other charges, such as processing fees, pre-closure charges, statutory fees and additional payments, also contribute to the total cost of borrowing.

2. How is interest rate calculated?

As outlined above, interest rate is usually expressed as a percentage of the principal borrowed. Different financial institutions charge different rates of interest on business loans, depending on a number of factors. However, as a borrower, it is crucial to understand the type of interest being charged: is it a flat interest rate or a diminishing interest rate?

In a flat interest rate loan, the interest amount is calculated on the full amount of the initial principal borrowed throughout the tenor of the loan. This means that the EMI on the loan remains the same throughout the repayment period. For instance, for a loan of Rs. 1,20,000 with a one-year tenor, payable in 12 installments at an interest rate of 10% per annum, your EMI payment will be Rs. 11,000 every month.

In a diminishing interest rate loan, interest is calculated on the outstanding principal amount. This means that the interest amount reduces with every installment that you pay. For the same loan, when paying a diminishing interest rate, your total repayment will come down to Rs. 1,26,500, with EMI payments reducing every month.

In the long run, diminishing interest rate loans are cheaper for business. However, choosing a flat interest rate business loan may also have benefits for your business. Knowing the type of interest charged and options available can help you choose the right option for your business.

3. What affects interest rate on business loans?

While the baseline interest rate is affected by external factors such as the country’s monetary policy, prevailing inflation rates and the general economy, the final interest depends upon the business.

The five major factors that affect interest on SME business loans are:

  • Business experience – For an SME that has been trading longer, business loans may be available at lower interest rates.
  • Business type – The type of business and the risk involved in its functioning has a considerable role to play in the cost of borrowing.
  • Creditworthiness – Your SME’s credit score, which represents its credit history and repayment capacity, weighs in strongly on the interest rate.
  • Financial health – The revenues and profits of the company also determine its ability to repay a loan and hence, the stronger the financial health of your business, the lower the interest charged on a loan.
  • Type of loan – If you choose a secured loan backed by collateral, the interest rate will be lower than what is charged on an unsecured loan for similar terms.

4. How can I obtain a lower interest rate?

Interest paid on a business loan can be a sizeable expense for an SME. Fortunately, there are ways to reduce your interest rate and get the best possible deal.

  • Compare interest rate charges and terms on business loans from different banks.
  • Find ways to improve your credit score. Any score above 750 can improve your chances of getting a lower interest rate on your business loan.
  • Focus on raising your revenues and profitability before applying for a new loan.
  • Take out a secured loan with a good-quality asset backing.
  • Apply for a business loan through CreditEnable to ensure you are matched with the right lender and right loan for your business’s particular needs.

Since different banks charge different interest rates, always clarify the type of interest before you sign the loan agreement. Calculate the impact it will have on your bottom line. Understanding this key component of borrowing and its implication for your business is essential before you commit to a repayment.