Interest Rates

TERM STRUCTURE OF INTEREST RATES

The actual interest on a loan is not fully known until the duration of the borrowing arrangement has been specified. Interest rates on loans are typically figured on an annual basis, though other periods are sometimes specified. This does not mean that the loan is supposed to be paid back in a year; indeed, many loans—especially in the realm of small business—do not mature for five or ten years, or even longer. Rather, it refers to the frequency with which the interest and "principal owed"—the original amount borrowed—are recalculated according to the terms of the loan.

Interest is usually charged in such a way that both the principal lent and the accrued interest is used to calculate future interest owed. This is called compounding. For small business owners and other borrowers, this means that the unpaid interest due on the principal is added to that base figure in determining interest for future payments. Most loans are arranged so that interest is compounded on an annual basis, but in some instances, shorter periods are used. These latter arrangements are more beneficial to the loaner than to the borrower, for they require the borrower to pay more money in the long run.

While annual compound interest is the accepted measure of interest rates, other equations are sometimes used. The yield or interest rate on bonds, for instance, is normally computed on a semiannual basis, and then converted to an annual rate by multiplying by two. This is called simple interest. Another form of interest arrangement is one in which the interest is "discounted in advance." In such instances, the interest is deducted from the principal, and the borrower receives the net amount. The borrower thus ends up paying off the interest on the loan at the very beginning of the transaction. A third interest payment method is known as a floating- or variable-rate agreement. Under this common type of business loan, the interest rate is not fixed. Instead, it moves with the bank's prime rate in accordance with the terms of the loan agreement. A small business owner might, for instance, agree to a loan in which the interest on the loan would be the prime rate plus 3 percent. Since the prime rate is subject to change over the life of the loan, interest would be calculated and adjusted on a daily basis.

THE INTEREST RATE AND SMALL BUSINESSES

Entrepreneurs and small business owners often turn to loans in order to establish or expand their business ventures. Business enterprises that choose this method of securing funding, which is commonly called debt financing, need to be aware of all components of those loan agreements, including the interest.

Business consultants point out that interest paid on debt financing is tax deductible. This can save entrepreneurs and small business owners thousands of dollars at tax time, and analysts urge business owners to factor those savings in when weighing their company's capacity to accrue debt. But other interest rate elements can cut into those tax savings if borrowers are not careful. Because interest paid on a loan is tax deductible, while other loan charges and fees are not, it may be in the best interest of a small business owner to accept a loan with a slightly higher interest rate if it offers fewer handling charges than a similar loan with a slightly lower interest rate but higher handling fees. The full impact of loan charges and interest rates over time should be made before deciding upon a lender.

Commercial banks remain the primary source of loans for small business firms in America, especially for short-term loans. Small business enterprises who are able to secure loans from these lenders must also be prepared to negotiate several important aspects of the loan agreement which directly impact interest rate payments. Both the interest rate itself and the schedule under which the loan will be repaid are, of course, integral factors in determining the ultimate cost of the loan to the borrower, but a third important subject of negotiation between the borrowing firm and the bank concerns the manner in which the interest on a loan is actually paid. There are three primary methods by which the borrowing company can pay back interest on a loan to a bank: a simple- or ordinary-interest plan, a discounted-interest plan, or a floating interest rate plan.

Securing long-term financing is more problematic for many entrepreneurs and small business owners, and this is reflected in the interest rate arrangements that they must accept in order to secure such financing. Small businesses are often viewed by creditors as having an uncertain future, and making an extended-term loan to such a business means being locked into a high-risk agreement for a prolonged period. To make this type of loan, a lender will want to feel comfortable with the business, the quality of its management, and will want to be compensated for what it sees as higher-than-usual risk exposure. This compensation usually includes the imposition of interest rates that are considerably higher than those charged for short-term financing. As with short-term financing arrangements, interest on long-term agreements can range from floating interest plans to those tied to a fixed rate. The actual cost of the interest rate method that is ultimately chosen appears in interest rate disclosures (which are required by law) as a figure known as the annual percentage rate (APR).

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