Top Factors Influencing Business Loan Interest Rates – Forbes Advisor INDIA
Business loans are an essential tool for entrepreneurs to manage and grow their business. This need is especially acute for small business owners, who don’t have as much cash flow and access to capital as larger companies. This is further complicated by the fact that Micro, Small and Medium Enterprises (MSMEs) in India find it difficult to find lenders who would give them loans without asking for collateral(s) or collateral.
Business loans as a category are designed to provide business owners with the necessary capital and the loans are structured similarly to comparable categories such as personal loans. However, the most important factor in issuing and repaying a loan is the interest rate, which is determined based on several factors.
Here are the factors that influence the issuance of business loans and their interest rates.
Macro factors and individual factors
Access to loans and loan rates can be determined based on several macro-factors such as:
- Sector and subsector of activity (is the sector or subsector an economically depressed sector or a seasonal activity?)
- Geographic reality (is the company subject to labor shortages, political or environmental instabilities?)
- Infrastructure (Does the local infrastructure of roads, electricity and other supply chain needs support the local business?)
Interest rates and terms of loans are governed at the individual level by determining the creditworthiness of the borrower. This is done by considering factors such as the payment history of the business owner, the loan amount requested and the purpose of the loan. However, the extent to which these factors impact the interest rate varies greatly from lender to lender.
For business loans, factors that play a role in choosing the loan term and interest rate include:
- Business profitability and cash flow analysis
- Business owner’s net income
- Type of business and how long it has been in operation
- Other existing loans, even if they are personal loans
For larger, more established businesses, lenders offer loans secured against property, which allows for a lower interest rate than is typically possible with an unsecured loan for a small or micro business, especially if the business owner is a first-time borrower.
The factor that has a strong influence on the likelihood of a business loan being approved, as well as the interest rate, is the creditworthiness of the borrower. This is based on several considerations which together are meant to reduce the risk of non-payment or default for the lender. Creditworthiness is primarily determined based on the borrower’s debt-to-income ratio and the borrower’s overall payment history against all other obligations, including other expenses and loans.
Traditional lenders require real estate collateral in exchange for a business loan to secure the issued capital. With a secured business loan, if the borrower fails to repay the loan amount, the lender can claim the asset instead of the amount, thereby recovering or partially recovering their claim. As a result, secured loans generally attract a lower rate of interest.
Traditional lending institutions like banks have stuck to the rigid frameworks of established credit history and real estate collateral to even consider applying for a loan. Many of them still require a considerable amount of documentation, including tax returns and detailed company financial statements. As a result, many small business entrepreneurs are repeatedly turned down by banks when approaching them for business loans. Complicated rules and collateral requirements are a deterrent to many new borrowers, who might not have the necessary documents at hand or even be able to navigate a long and complicated loan application process without support and guidance in their local language.
Without a formal loan, one cannot establish one’s credit history and without real estate collateral, one cannot obtain a loan. This catch-22 has left many people significantly locked out of access to credit.
Obtaining a loan with real estate collateral is a method of exclusion, because it prevents many entrepreneurs from accessing the capital they need to develop their business.
Many lenders, especially those focusing on financial inclusion, including non-bank financial companies (NBFCs) and microfinance institutions (MFIs), offer alternatives to MSMEs, many new era lenders use creative way of technology-driven digital methods to issue unsecured loans that do not rely on real estate collateral. While this may seem to increase the risk on the part of the lender, many organizations are now proving that serving the underserved MSME market can lead to sustainable business growth for entrepreneurs and for the organization itself.
Technology-led risk assessment
Technology-driven risk assessment models help entrepreneurs, especially new borrowers. This is where traditional credit rating methods are not needed. The technology allows lenders to be more flexible and work with the data points available to them to assess creditworthiness by creating their own dashboard. Fintechs are relying on data-driven credit decisions to underwrite loans, which is finally bringing many consumers and businesses into the credit fold.
For the new generation of borrowers new to credit, there is a need for alternative risk assessment models that rely on factors other than the availability of a credit bureau report, or even a credit history. Filing of Goods and Services Tax (GST) returns. The extent to which lenders can assess credit risk and grant loans with confidence depends on their established processes and technological sophistication. The use of artificial intelligence or machine learning models can facilitate faster response and real-time updating of factors that can determine interest rates.
A combination of digitization of technology-driven risk assessment processes, such as the provision of video-KYC, electronic disbursements and digital wallet payment options, can be used to provide credit in a fast and secure manner.
Data-driven decision making makes the process fast and accurate, and removes human bias from credit decision, which is especially important when serving the underserved MSME segment.
By improving the efficiency and ease of the risk assessment process, lenders can offer a variety of loan options to a wider group of borrowers.