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Small businesses in every industry can benefit from using a small business loan to finance their basic operational and growth needs. They can use a loan to cover expenses like purchasing new inventory to prepare for higher sales, buying or renting equipment, expanding their business with greater real estate, or covering day-to-day operating expenses. And because small business loans come with fewer strings and stipulations than venture capital, this funding is some of the most flexible cash businesses have access to.
According to Federal Reserve data, the average small business loan among all banks and institutions is for about $663,000 — though that data only includes commercial and industrial loans. The Small Business Association, on the other hand, tends to offer smaller loans with more competitive interest rates. As a result, the average SBA loan size is just $107,000.
While taking out a loan like this can help your small business meet its financial needs and expand quickly, it’s essential to understand the true cost of your loan before you utilize the funding. Knowing the real cost you’ll pay in the long run may not change your decision to take out a loan, but it can help you build a more accurate cash flow and revenue forecast for the next few years.
A number of factors determine the cost of your small business loan, but these three factors have the biggest impact on your bottom dollar:
1. Interest rates
As a quick refresher, an interest rate is the percentage of the total amount of your loan that your financial institution charges for using that money. Interest rates have the single biggest impact on the long-term cost of your loan — and they can vary widely based on the type of loan you apply for, the loan terms, the length of your loan, and the type of interest charged.
Interest rates can vary from as low as 3% to as high as 80%, depending on the type of loan you choose and how quickly you pay that loan back. Your small business’ high credit score may allow you to qualify for a lower rate, while businesses with poor credit may have to pay a higher interest rate and additional fees.
Market conditions can also impact the interest rate you’re offered. In 2020 and 2021, while the federal reserve rate was at a historic low, banks offered exceptionally low loan interest rates. But today, those rates are rising quickly. Businesses are advised to shop around for the best interest rate available for their loan type and consider fixed-rate loans that won’t fluctuate as the reserve rate rises.
Loan repayment terms are the rules that govern how you’ll pay the loan back over time. They stipulate the length of time you have to start making payments and pay off the full loan, they define the required frequency of your payments, and they outline any fees you may be charged for late payments or an early loan payoff.
Shorter-term loans, like 12-month or 24-month loans, tend to cost less than longer loans (think 10- or 15-year loans), because less interest is charged over the life of the loan. But they also result in higher periodic loan repayments.
To determine how much your loan will really cost your small business, monthly and in the long run, try using a business loan calculator to determine your overall borrowing cost and monthly expenses. As you input different loan terms and interest rates, you may find that your cash flow limits your loan options to long-term loans, or that you can significantly reduce the cost of your loan by paying it off quickly.
3. Loan fees
The third factor that can impact the cost of your small business loan, in addition to interest rates and your loan repayment terms, is loan fees. These can vary widely based on your lender, loan type, and if you’re making timely payments.
The most common loan fees to ask about before you take out a small business loan are:
The application fee. This covers the lender’s cost in administering the loan.
Origination fees. Charged when the loan is created.
Underwriting fees. This covers the cost of assessing your business’ creditworthiness and overall risk.
Late payment penalties. If you miss a payment, you may be charged a significant fee based on how many days your payment is late.
Prepayment penalties. If you pay your loan off early, you may be charged a prepayment fee to cover the interest the bank loses.
These fees, even small ones, can add up quickly. That’s why using a detailed loan calculator, or consulting a small business CFO, to determine how the loan will impact your bottom line is essential.
Taking out a small business loan can be a great benefit to your business — if you understand its true cost
Taking out a small business loan can help your business expand, reposition, or get through a slow season. But it can also limit your cash flow and hurt your profits. Before you start applying for funding, consider every factor that adds to the overall cost of your loan — so you can find the best, most affordable option for your small business.
Want more? Escalon has helped over 5,000 companies across a range of industries to optimize routine business functions, like taxes, accounting and HR. Talk to an expert today.
This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage with Escalon, please contact us here.
Tasnim Ahmed is a content writer at Escalon Business Services who enjoys writing on a multitude of subjects that include finops, peopleops, risk management, entrepreneurship, VC and startup culture. Based in Delhi NCR, she previously contributed to ANI, Qatar Tribune, Marhaba, Havas Worldwide, and curated content for top-notch brands in the PR sphere. On weekends, she loves to explore the city on a motorcycle and binge watch new OTT releases with a plateful of piping hot dumplings!