How are interest rates calculated on business lines of credit?
Business lines of credit: How rates are determined
- Traditional lines of credit offer lower interest rates but are harder to obtain.
- Nontraditional lines are easier to obtain but carry higher interest rates.
- Rates depend on credit scores, time in business, liquidity and collateral.
Business loans can be powerful tools to help your company thrive, but it is important to understand the different types of loans and interest rates so you know how much they will cost your business.
Term loans vs. lines of credit
The primary difference between a business term loan and business line of credit is that the former offers a fixed loan term — hence the name — and the latter is a revolving credit facility. This has an influence on how their respective interest rates are calculated.
While both business term loans and lines of credit can carry fixed or variable interest rates, typically term loans feature fixed rates and lines of credit have variable rates pegged to the prime rate, which means they adjust upward as the prime rate rises.
A term loan has a higher interest rate that is set when the loan is taken out. Payments are a fixed amount over a fixed term, making it a sensible option for a long-term, single-use loan. Business lines of credit, by contrast, have lower interest rates, and interest is only paid on cash drawn. The initial lower monthly payments on a business line of credit make it ideal for short-term and unexpected expenses.
Secured vs. unsecured
For all business lines of credit, when determining interest rates, lenders look at the company’s small-business credit report or the owners’ FICO credit scores, overall liquidity, time in business and available collateral. Strong credit, robust financials over a longer duration of time and the ability to pledge capital or short-term assets to secure the line of credit all improve a company’s chances of obtaining a favorable interest rate.
Secured lines typically offer higher credit limits at lower interest rates because the lender is protected by the collateral backing the loan. Traditional unsecured lines of credit also offer low interest rates, but are only realistic for businesses with strong balance sheets because of the rigorous qualification requirements.
Nontraditional unsecured lines, such as credit cards, feature the highest interest rates among the various business lines of credit. They are fast and easy to obtain, however, even for small and growing businesses that have yet to develop strong credit or demonstrate consistent profitability. Oftentimes nontraditional unsecured lines offer zero percent interest for a finite introductory period.
Start with an understanding of your company’s creditworthiness and business objectives before discussing loan options with a lender. Depending on your company’s financial needs, a fixed-rate term loan or a responsibly managed business line of credit can provide a vital cash-flow lifeline that protects against a significant business interruption or helps to finance resources necessary for company growth.