Understanding Small Business Loan Costs
The monthly payment is only part of the picture. What matters is the total cost of capital—the full amount you pay above and beyond the money you received. A $100,000 loan at 9% over five years costs you roughly $24,600 in interest alone. Add a 2% origination fee and the true cost climbs to $26,600. That is money that could have gone toward hiring, inventory, or marketing.
Understanding the real cost lets you make an informed decision: is the return on the investment this loan funds greater than the cost of the loan itself? If the answer is no, debt destroys value instead of creating it.
SBA Loan Rates: The Gold Standard
The U.S. Small Business Administration does not lend money directly. Instead, it guarantees a portion of loans made by approved lenders, reducing their risk and allowing them to offer better terms to borrowers. SBA 7(a) loans—the most common type—typically offer rates of prime plus 2.25% to 2.75% for loans over $50,000, with terms up to 10 years for working capital and 25 years for real estate.
SBA loans are competitive but require more paperwork, longer processing times, and strong personal credit. If you qualify, they almost always beat conventional small business loans on total cost. The SBA 504 program is another option for equipment and real estate, offering fixed rates and longer terms.
Comparing Loan Types
Not all business loans are created equal. Here is how the major categories compare according to data from the Federal Reserve:
- SBA 7(a) loans: 6–10% APR, terms up to 10 years, best for established businesses with good credit. Lowest total cost but slowest to fund.
- Bank term loans: 7–12% APR, terms of 1–5 years typically. Require strong financials and collateral. Competitive rates for qualified borrowers.
- Online lenders: 10–30%+ APR, terms of 3–36 months. Fast funding (sometimes same-day) but significantly more expensive. Best for short-term working capital needs only.
- Equipment financing: 6–15% APR, terms matching the equipment’s useful life. The equipment itself serves as collateral, making qualification easier.
- Business lines of credit: 8–24% APR, revolving. You only pay interest on what you draw. Good for managing cash flow gaps, but rates can be higher than term loans.
- Merchant cash advances: Effective APRs of 40–150%+. These are not technically loans but advances against future sales. The total cost is extreme. Avoid unless you have exhausted all other options.
When Debt Makes Sense for Small Business
Debt is a tool, not inherently good or bad. It makes sense when the return on the investment clearly exceeds the cost of capital. Here are situations where borrowing typically creates value:
- Revenue-generating equipment: A $50,000 machine that produces $80,000 in annual revenue with $20,000 in operating costs generates $60,000 in gross profit. Even at 10% interest, the loan pays for itself in the first year.
- Inventory for a confirmed order: If you have a signed contract but need capital to fulfill it, a short-term loan bridges the gap between spending and getting paid.
- Hiring that directly drives revenue: Adding a salesperson or technician who will generate measurable revenue can justify borrowing, as long as the payback period is reasonable.
- Real estate with equity upside: Buying your commercial space instead of renting builds equity and locks in costs. Over 10–25 years, ownership almost always wins.
Debt is dangerous when used to cover operating losses, fund lifestyle spending, or invest in projects with unclear returns. The SCORE resource library offers free financial projection templates to help you model whether a loan-funded investment will generate positive returns.
The Cost of Capital Framework
Professional investors use a concept called the weighted average cost of capital (WACC) to evaluate investment decisions. As a small business owner, you can use a simpler version: if the return on an investment is higher than the interest rate on the loan funding it, the investment creates value. If it is lower, the investment destroys value.
For example, if a $100,000 loan at 9% funds a project that generates $20,000 in annual profit (a 20% return), the spread between the return (20%) and the cost of capital (9%) is 11 percentage points of value creation. That is a good use of debt. But if the same loan funds a project returning only 5%, you are losing 4 percentage points annually—you would be better off not borrowing at all.
Reducing Your Borrowing Costs
Before you accept the first offer, take steps to minimize what you pay:
- Improve your credit score. Even a 50-point improvement can drop your rate by 1–2 percentage points, saving thousands over the life of the loan.
- Offer collateral. Secured loans carry lower rates because the lender has recourse if you default.
- Shorten the term. A 3-year loan at the same rate costs far less in total interest than a 7-year loan, even though the monthly payment is higher.
- Negotiate the origination fee. Fees are often negotiable, especially if you have competing offers.
- Get multiple quotes. Banks, credit unions, CDFIs, and online lenders all price differently. Getting three to five quotes is standard practice.
Sources
- U.S. Small Business Administration — Loan Programs — SBA loan types, rates, and eligibility requirements
- Federal Reserve — Consumer Credit (G.19) — Current interest rate data for commercial lending
- SCORE — Templates & Resources — Free financial projection templates and loan analysis worksheets