Small Business Loan Terminology — Speak the Language, Save Money

When you’re obtaining a small business loan for the first time, the terminology can be very confusing. To help you along the way, we’ve compiled a list of the most important lending terms that you’ll encounter. The terminology is broken into the two main categories you want to consider when financing a small business — loan pricing (how much the loan costs) and loan terms (how your loan is structured).

Business Loan Terminology: Loan Cost

Origination Fee

To understand the true cost of a loan, you must dig into the fees. Origination fees are charged to compensate the lender for arranging the loan, and are deducted from the loan amount. Origination fees of 3 to 4 percent are typical for small business loans, and are one of the more substantial fees you’ll encounter.

 APR (Annual Percentage Rate)

APR reflects the yearly cost of funds over the term of a loan, including additional costs like fees. For loans with terms of one year or more, APR gives borrowers a simple way to compare the actual costs of loans. Nite: APR is different from interest rate, which only takes into account the interest on the loan, not the fees.

APY (Annual Percentage Yield)

One limitation of APR is that it doesn’t account for the effect of compounding interest. For example, if your APR is 12%, meaning your monthly rate is 1%, your balance accrues 1% interest each month.

With a beginning balance of $10,000 and a 12% APR that compounds monthly, your balance will increase by $100 after the first month. Your second month’s balance of $10,100 will then increase by another 1% (101). This compounding continues for the year, and APR doesn’t account for it.

APY is the effective annual rate of return taking into account the effect of compounding interest. APR is often the best quick measure of a small business loan’s cost, but if you want to dig deep, APY is more accurate.

Factor Rate

Short-term business loans are sometimes priced using a factor. Simply put, factor = payback amount ÷ loan amount. (i.e., A $20,000 loan with a $23,000 payback would have a factor rate of 1.15.) Factor is an easy way to reflect the cost of a loan when the term is less than a year, and therefore APR wouldn’t be as relevant.

Business Loan Terminology: Loan Terms

Fixed and Variable Rate

Fixed loans have a predetermined interest rate that you and the lender agree on before signing the contract. Variable rate loans are usually tied to an index; depending on the index’s performance the interest rate on your loan may go up or down. Alternately, variable rate loans may start at a certain rate and then go up at a predetermined time.

Default Interest Rate

This rate is used by all types of lenders, from banks to credit card companies and small business financiers. Default interest rate is the rate you pay when you’re behind on your payments. It’s usually very high because it’s the lender’s way of incentivizing you to get up to date with your payments.

Prepayment Penalty

Exactly as it sounds, a prepayment penalty is a fee you pay for paying your loan off at a date earlier than the one you agreed upon. Some prepayment penalties may only be in effect for a certain amount of time. For example, you may be subject to a penalty if you repay your loan within six months, but after the initial six months you may pay without being penalized.