Be it young businesses, MNCs or SMEs—business loans are a handy tool for all. A business loan helps an organisation manage its cash flow, inventory and delays in payment cycles. While raising working-capital, it helps to understand how a business loan interest rate is calculated. This can help SMEs save a significant amount of money.
At the outset, the business loan interest rates depend on the loan amount and its tenure. There are two types of interest rates: Diminishing Rate of interest and Flat Rate of interest.
As the borrower starts paying the EMIs, the principal amount reduces over time. Hence, it seems fair that in the subsequent EMIs, the interest be applied only on the outstanding principal and not on the entire sum that was initially borrowed. This method of calculating business loan rates is known as diminishing rate of interest. Capital Float uses the diminishing rate of interest model for Online Seller Finance, Pay Later, Supply Chain Finance and Unsecured Business Loan.
In contrast, flat rate of interest refers to the practice of computing the interest for all EMIs on the entire initial amount borrowed. It does not take into account the diminishing value of the principal after one or more EMIs are paid.
It’s easy to see why the borrower would prefer the diminishing rate model to compute business loan interest rate in India. Let’s consider an example. Suppose an SME borrows Rs 10,00,000 for a period of three years (at an SME loan interest rate of 10%). Here’s how differently the total interest amount paid varies.
|Flat Rate (10%) – 36 months||Diminishing Rate (10%) – 36 months|
Loan Amount = 10,00,000
EMI = 36,111
Total Interest = 3,00,000
Total Payments = 13,00,000
Loan Amount = 10,00,000
EMI = 32,267
Total Interest = 1,61,619
Total Payments = 11,61,619
Clearly, for the same loan parameters, the diminishing rate model is favourable to the borrower. However, in reality, the lender sets a higher business loan interest rate for a diminishing rate model.
The lending institution will assess the risk of every loan application against a set of guidelines. Some of the common parameters are:
In addition to the interest, the lender may levy other business loan charges such as processing fees, stamp duty, Commission on Letters of Credit (LC) and Bank Guarantee (BG), foreclosure charges and other statutory charges.
Therefore, a sound understanding of all applicable fees, business loan interest rates, and repayment options is necessary before you file a loan application.