TL;DR: Short-term loans with high annual interest rates might work out cheaper in the long-run, and mean you’re free of debt sooner.
In most situations, interest rates are a great way to compare different financial products. If you’re looking for a savings account, you’re likely to go for the accounts with high interest rates. And if you’re looking for a credit card, you’re likely to go for the cards with low interest rates.
Most people don’t have the time to become financial experts, so interest rates can be a handy way of summarising the benefits – and disadvantages – of one financial product over another.
But in certain circumstances, they can be a misleading indicator. This is especially the case when it comes to short-term business finance.
Why are interest rates helpful?
Interest rates are designed to be used when you’re comparing similar products, and they can be a powerful figure when they’re used properly.
For example, if you’re comparing loans for the same amount and the same term from different providers, the interest rate will tell you which one is likely to be the most cost-effective.
Obviously, there are other factors that you should consider – but the interest rate gives you a quick, top-line impression.
From the lender’s point of view, they’re also very helpful as a marketing message. An interest rate is a simple number that they can use in their advertising which can give them an advantage over their competitors.
Why can interest rates be misleading?
The problem with interest rates comes when they’re used to compare products that are not the same. They can also be tricky when they’re used in isolation. Put simply, interest rates do not tell the whole story.
Compare the interest rate on a short-term business loan with one that’s long-term and the short-term loan will seem far more expensive.
This is because most interest rates are shown as a percentage of how much interest you’ll pay across the course of a year.
If the loan has a term of a few years, the interest is spread out over those years and the annual interest rate will be lower. However, if the loan only has a term of six months, the annual interest rate will be far higher because you’re paying it all off in less than a year.
So does that mean the long-term loan is cheaper overall? Not necessarily.
How else can you compare loans?
Rather than just looking at the annual interest rate, there are a number of factors you can consider as well:
How much will you pay in total?
One of the most important to look at is the total amount you’ll pay back across the term of the loan. This is especially handy for comparing short-term and long-term loans.
The short-term loan might have a high interest rate but you may end up paying less in total than with a five-year loan. You’ll also benefit from clearing the loan much faster (more about that in a bit).
|Term||Annual interest rate||Total amount repayable|
For example, a loan of £20,000 borrowed over a period of six months with an annual interest rate of 55% would cost you £23,327.75 in total.
Whereas the same amount borrowed over five years with an interest rate of only 8% would cost you £24,333.97 – that’s over £1,000 more.
Do you have assets to offer as collateral?
Another important thing to consider is whether or not you’re comfortable securing any assets against the loan.
Offering an asset such as your house as collateral can give you access to a lower interest rate. However, if you’re unable to keep up with the loan repayments, you may risk losing that asset.
Many business owners do not even have the option of securing their loan in the first place. This is particularly true if you don’t own your own home or if your business doesn’t have any assets.
Unsecured loans – where no assets are required for security – tend to attract a higher interest rate as they involve more risk for the lender.
How long will it take you to pay off?
You should carefully consider how important the term of the loan is to you. Spreading your repayments over a longer period might sound like a great idea at first but it can have its downsides.
By taking out a long-term loan, you could be limiting your access to additional finance in the future. Many lenders may be unwilling to give you more credit if you still have a loan outstanding.
One of the biggest advantages of short-term finance is that you clear the debt quickly, leaving you free to apply for other finance if and when you need it.
How quick and easy is the application process?
Another really important factor is how quickly you can get hold of the money. Chances are, if you need capital for your business, you need it pretty quickly!
Traditional bank loans with low annual interest rates usually involve long-winded application and approval processes. You might have to submit full accounts along with detailed business plans.
On the other hand, short-term loans like those offered by Boost Capital involve a much faster application process. With us, you can get an instant decision and funds in your account in as little as two business days.
Be careful when you’re comparing business finance products – and make sure you take more than just the interest rate into account when you’re shopping around. Look at the bigger picture and where possible, try to compare like-for-like.
You should also think about what you need the funds for. Do you need money for a long-term investment where you’re comfortable spreading the payments over a few years?
Or do you only need a quick injection of cash for something more short-term – like paying for a tax bill or buying more stock for an upcoming busy period?
The benefits of short-term, unsecured finance may outweigh the initial attraction of a low interest rate.
We’ve built a business loan calculator so you can compare quotes from different lenders.