Unsecured business loans, while enticing due to their lack of collateral requirement, can often carry higher costs. The inherent risk these loans pose to lenders, given the absence of tangible security, usually translates to higher interest rates compared to secured loans.
Beyond interest, businesses must also account for potential origination fees, processing charges, and other hidden costs that may be attached to the loan agreement.
These costs can vary widely depending on the lender, the creditworthiness of the borrower, the amount being borrowed, and the duration of the loan.
Therefore, when evaluating the viability of an unsecured business loan, it’s paramount for businesses to fully understand and factor in these costs to ensure they’re making a financially sound decision.
What are unsecured business loan costs are based on?
Unsecured business loan costs are based on factors such as the interest rate, loan amount, loan term, lender’s assessment of the borrower’s creditworthiness, and any associated fees or charges.
Here are a number of factors:
Interest rates
When securing a loan, the interest rate significantly influences its overall cost. Interest rates tend to be steeper for unsecured loans, given the higher risk assumed by lenders in the absence of collateral.
There are two primary methods of calculating interest: simple and compound.
Simple interest is calculated based on the initial amount borrowed, the rate of interest, and the loan’s duration. To illustrate, on a £10,000 loan at a 5% interest rate, you’d incur £500 in interest annually. Over a three-year period, this would amount to £1,500 in total interest (£500 x 3 years).
On the other hand, compound interest is more commonly adopted by lenders. With this method, interest is charged not only on the principal sum but also on any accrued interest. For instance, on a £10,000 loan with a 5% interest rate that compounds yearly and spans over 5 years, the total interest accrued would be £1,322.74. Utilising a loan calculator can provide clarity on how interest compounds for varying loan sums.
APR
The annual percentage rate (APR) represents the yearly expense of a loan. This encompasses both the interest rate and any associated fees, and it’s denoted as an annual percentage. Given that the APR provides a comprehensive view of the full loan expenses, its rates typically appear greater than the basic interest rates.
Factor rates
The factor rate offers an alternative method to ascertain the cost of a loan, predominantly associated with short-term business loans or cash advances in the UK.
Unlike interest rates which are represented as percentages, factor rates are denoted as a decimal. To calculate the total amount to be repaid using a factor rate, one multiplies the borrowed amount by this rate:
Loan amount x factor rate = total repayment amount
For example, if a loan carries a factor rate of 1.2 and you borrow £10,000, the repayment sum will be £12,000 (£10,000 x 1.2 = £12,000), excluding any other fees.
It’s prudent to translate a factor rate into an APR when comparing various loan offerings in the UK market, allowing a clearer understanding of how costly loans with factor rates might be in relation to those with standard interest rates or APR.
Fees
When exploring the option of an unsecured business loan, it’s crucial to account for various business loan fees, which can differ depending on the lender. Below are some typical fees you might come across:
| Fee Type | Description |
|---|---|
| Annual Fee | Some lenders charge a yearly fee for business lines of credit to keep them active. |
| Application Fee | This fee may be charged when submitting an application for the loan. |
| Closing Costs | Often associated with commercial real estate loans, similar to mortgages. Can encompass attorney fees, appraisal fees, credit report fees, and more. |
| Draw Fee | Certain business lines of credit levy this fee when you withdraw money from your account. |
| Late Payment Fee | This penalty fee is charged when a payment is made after its due date. |
| Maintenance Fee | Similar to an annual fee, but charged either monthly or yearly for keeping a business line of credit active. |
| Non-sufficient Funds Fee | If there are insufficient funds in your account when the lender attempts a withdrawal for a payment, an NSF fee may be charged. |
| Origination Fee | Typically a percentage of the loan amount, charged upon initiating the loan. The standard range is 0.5% to 5% of the loan amount, though some lenders might charge up to 8% or more. |
| Prepayment Penalty | A fee that some lenders charge if the loan is repaid earlier than stipulated. |
| Underwriting Fee | This fee is for the underwriting process, wherein the lender determines the loan amount and interest rate you’re eligible for. It can sometimes be part of origination fees, but might also be separate. |
Repayment terms
Every loan is associated with specific repayment conditions, which dictate the duration you have to settle the debt. By adhering to the stipulated monthly payment amount, you’ll clear your loan within the set repayment period.
Making overpayments monthly can be advantageous, allowing you to clear your debt faster and potentially save on costs. Given the nature of compounding interest, paying a higher amount earlier reduces the principal and, subsequently, the interest accumulated on it. However, ensure your lender doesn’t impose a penalty for early repayments.
Other factors that impact the cost of an unsecured business loan
Securing beneficial interest rates and loan conditions often hinges on certain aspects in your profile. Your credit rating, the duration your business has been operational, and the income you generate play crucial roles in shaping the offers you receive from lenders. The more impressive these figures, the more favourable your loan conditions and interest rates, ultimately leading to a more cost-effective business loan.
For those with subpar credit histories, there are specific business loan alternatives available. However, be prepared for steeper interest rates, making the loan pricier overall.
Read more: Difference between unsecured and secured business loans?
Frequently asked questions
How much does it cost to get a business loan?
The cost of obtaining a business loan varies based on factors such as the interest rate, fees, loan amount, and the loan's term. Typically, besides repaying the principal amount borrowed, businesses also pay interest and might incur additional fees like origination, application, or maintenance fees.
What is a good interest rate for a business loan?
A good interest rate for a business loan varies depending on economic conditions, but typically, rates between 3% and 7% are considered favourable for established businesses with strong financials in the UK. However, newer businesses or those with weaker credit profiles may encounter higher rates.
How long are business loans usually for?
Business loans typically have terms ranging from a few months to 10 years. Short-term loans might last a few months to 2 years, while long-term loans usually span from 3 to 10 years.
Conclusion
In conclusion, the cost of an unsecured business loan in the UK encompasses more than just the borrowed amount. Factors such as interest rates, fees, and the loan’s term play pivotal roles in determining the overall expense. Since unsecured loans don’t require collateral, lenders often offset the higher risk with steeper interest rates.
It’s imperative for businesses to thoroughly understand all associated costs, compare offers from various lenders, and consider their financial position before opting for such a loan. By doing so, businesses can make well-informed decisions that support their growth while managing financial liabilities effectively.
Lee Jones is a seasoned Business Finance Specialist with over two decades of invaluable experience in the financial sector. With a keen eye for market trends and a passion for helping businesses thrive, Lee has become a trusted advisor to countless organizations seeking to navigate the complexities of finance.