Which Factors Affect the Interest Rate on Small Business Loans?

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Factors Affecting the Interest Rate on Small Business Loans

A quick look at 4 factors that play a key role in determining the interest rate on MSME loans

If you have looked online for MSME loans, you would have seen that banks and other lending institutions usually do not disclose the interest rate levied on business loans. They may give a formula of the interest rate where it is defined as a sum of two or three factors namely, Marginal Cost of Funds based Lending Rate (MCLR) of the bank, Strategic Premium and Credit Risk Premium. Or, just say that the interest rate may range from X% to Y%.

However, there will always be fine print somewhere at the bottom of the page stating that the actual interest rate depends on different factors. Do you want to know what those factors are? Well, you are in luck. In this article, we are going to discuss 4 factors that play an important role in determining the interest rate on MSME loans.

Let’s take a look, shall we?

#1 Risk Rating

This should not come as a surprise to you since banks always look for credible borrowers. And who can be more credible than a borrower with a perfect credit score?

This is because credit score shows how good a borrower has been in repaying their previous debts and how likely they are to do so again. In certain cases, banks may reject a loan application after looking at the poor credit score of a borrower or a business, or levy a higher interest rate for risk mitigation.

This is one of the main factors that affect the interest rate on MSME loans (all types of loans actually). The “Credit Risk Premium” factor in the interest rate formula corresponds to the risk rating of the borrower.

#2 Quantum of Loan

In many cases, banks can offer a different interest rate based on just different loan amounts. A higher loan amount may attract a lower interest rate. This is probably because they want businesses to borrow money based on their needs instead of going for a lower loan amount as it will not earn them much.

Banks want borrowers to go for a higher loan amount, while keeping their repayment capacity in mind, so they offer a relatively lower interest rate on higher loan amounts. This makes more business sense as they get to earn a higher interest rate.

#3 Repayment Period

For the same interest rate, a higher repayment period means more accrued interest as compared to a loan with a lower repayment period. But then borrowers will not go for a long repayment period. Would they?

To make it more desirable for borrowers to get loans for a longer repayment period, which benefits the bank, the banks may offer a relatively lower interest rate as compared to loans for a shorter repayment period.

#4 Type of Business

Banks have their own preferences when it comes to types of business and may offer a lower interest rate to certain businesses when it comes to MSME loans. This can also happen if they are running special schemes for businesses in certain industry sectors. Manufacturing, services and trading sectors always rank high in these lists since they play a huge role in the economy.

A Final Word

Now you know which factors play an important role in influencing the interest rate levied by banks on MSME loans. If you want to know more about MSME loans offered by Indian banks, you can check out our MSME loans page. We have covered popular small business loan schemes offered by major Indian banks in some detail for your reference.

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