Business owners and entrepreneurs need business loans, and their attention is always drawn towards interest rates and how they can secure loans with the least interest rate. Business loans are categorised into working capital, equipment, and special purpose loans.
The reserve bank of India fixes the repo rate that facilitates loans to have lower interest rates. The repo rate is basically the rate at which the RBI lends money to banks and financial institutions. The repo rate is increased when inflation increases. An increase in the repo rate causes lesser businesses to apply for business loans. The objective of the RBI is to discourage borrowing during inflationary times by raising the repo rate. Most banks and financial institutions lend money to businesses at interest rates that are based on the repo rate. There are 2 components. The first is the repo rate which has been capped at 4%, and the second component is the reverse repo rate. The reverse repo rate is the central banks’ lending rate which is presently 3.5%.
Business loan interest rates are calculated in two ways.
The first of these is the diminishing interest or diminishing balance. Each EMI or equal monthly instalment has principal and interest components. With each EMI, the principal amount begins to diminish, and the interest is calculated for the following month on the balance of the principal amount remaining. This method increases the interest component every month if the EMI amount remains the same.
The second is the fixed interest rate. In this method, the total interest is calculated for the principal in terms of the period of repayment and remains fixed throughout the period of the loan.
Factors that influence the interest rates on business loans
Several factors influence the business loan interest rate.
The first of these is the repayment pattern of the business loan. The bank or financial interest to which a business loan has been applied will check on the past history of the business to see if the business has paid its EMI’s in time and has no record of delayed payments or defaults. The lender will also check to see how many loans the business is operating in parallel and whether all the EMIs are being paid in time or not. An impeccable record with no history of defaults will entitle the business to a lower interest rate.
An important criterion is the nature of the business. Lenders would like to see if the business is seasonal and is active for only a few months of the year. An example is a business that manufactures air coolers. This business is seasonal and is active during the summer months only. Lenders also evaluate the nature of the risk of the business. If a business is perceived as high risk, the lenders will either refuse to pay out a loan or charge a higher rate of interest.
Business financials are an important factor that often come under the scrutiny of lending institutions. This is an evaluation of the financial health of the business. The things that are studied are the balance sheet, the profit and loss account and the cash flow. The business must have been set up at least three years before a loan is applied. Lenders perceive consistent financial health, good cash flow and regular profits in the business as low risk and interest rates are lower. Thus, businesses need to keep their financial condition in order if they are to apply for loans regularly, or they will need to pay higher interest every time.
Personal and business creditworthiness- One of the first things that a lending institution will check is the applicant’s credit rating. Here, the creditworthiness of the business owner as well as the business will both come under the scanner. The CIBIL score is considered to be the most reliable, and a credit rating of 850 points and above will be considered good. Both the business and the business owner will need to clear existing loans and past debts to get a high CIBIL score. The higher the credit score, the lesser will be the interest rate charged. Creditworthiness is also measured by the percentage of the EMI against the total turnover or profit of the business. If the total EMIs are more than 50% of the total revenue generated by the business, a new business loan application may be turned down.
Market Conditions play an important role in the sanction as well as the interest rate charged on a business loan. The interest rate is higher during inflationary or recessionary conditions as the government’s objective is to reduce the number of business loans to maintain economic balance and keep inflation under check.
Personal rapport with lenders is a very important criterion in a business environment such as India, where a lot of business is conducted on the basis of personal and family relationships. Maintaining regular good relations with a particular lender will help get a new business loan at the lowest possible interest rates.
Why do loan interest rates change?
Business loans, as well as general loan interest rates, change due to several factors. The main reason is the economic conditions. If economic conditions deteriorate, interest rates are hiked to discourage the taking of loans. Suppose the government is also taking loans for large infrastructure projects. In that case, there is what is known as crowding out, and financial institutions raise interest rates to reduce crowding out. Another reason for increasing interest rates in inflation. Raised interest rates may be lowered once inflation comes under control.
How to get a business loan at a lower interest rate?
There are several ways to get a business loan at a lower interest rate.
- The first is to improve one’s credit rating and get a CIBIL score of at least 850 to be eligible for lower interest rates. The next way is to demonstrate having quality tradelines. This can be done by repeatedly demonstrating paying back loans in time to establish credibility with lenders, and the interest rates get lowered with each positive cycle.
- A good presentation makes a good impression, and a loan application with a presentation and overview of the business with positive results will impress the lenders and help get a business loan at lower interest rates.
- A business also needs to show a larger employee size as lenders prefer to provide loans to larger companies. Once lenders are satisfied that the enterprise has a reasonable size, the perceived risk is lowered, and a lower interest rate can be negotiated.
- The best way to get a business loan at lower interest rates is to have good relations with the lender. This will not only help the financial institution to know the enterprise better. They will perceive a lower risk as they will know the company and its owners. Lower interest rates can then be negotiated in a friendly environment.
Tips to go about shopping for a business loan
For new businesses, an extensive search and market research is necessary. It is also necessary to carefully study the terms and conditions of different lenders and select the one with the lowest interest rates as well as the most flexible repayment terms.
It is best to choose a loan with short repayment terms. EMIs may be more, but the interest rate will be less as the business will pay lesser interest. This practice is good for working capital loans where the term of the loan is one cycle from raw material purchase to shipping of finished goods.
- Can a business be charged lower interest for preclosure of a business loan?
A lender may not charge lower interest on a promise of early foreclosure. But lower interest will be charged if the business has a repayment history of paying back loans before time.
- Can a loan interest be reduced if the repo rate is reduced during the term of the loan?
This normally does not happen, but the business can balance transfer the remainder of the loan to a new loan with lower interest based on the revised repo rate.
- Does a business loan need collateral?
Most business loans are unsecured, and hence no collateral is required.
- Can an enterprise take more than one business loan at a time?
A business can take more than one business loan at a time, but the total EMI cannot be more than 50% of the profits generated by the business.
- Can a business seek a government subsidy on a business loan?
Most government subsidies are for MSME. The business needs to qualify for being an MSME. Businesses can seek government financing where there are subsidies.
- Can a partnership firm get a business loan?
Yes, a partnership firm is also eligible to apply for a business loan. The firm can mention its type of partnership in the business loan application.
- Can be business loan be applied online?
Most business loans are applied, approved as well as sanctioned online.
- Can any type of business get a business loan?
Most lenders provide loans to selected businesses only. Businesses are advised to check the eligible business for loans before applying.
- Can a business loan with a diminishing balance system of interest calculation be foreclosed?
Foreclosure of a business loan is permitted for loans with both fixed and diminishing balance interest.
- Can a new business loan be applied while the previous loan is still being paid?
This can be done using a top-up loan.