The headline rate in a loan agreement tells you less than you might think. How often interest is calculated, whether unpaid interest is added to the debt, what the rate is tied to and what happens on default can all change what the loan actually costs. These are the points to check in the interest clause before you sign.
Simple and compound interest
Simple interest is charged only on the amount borrowed. Say you borrow £10,000 at 5% a year simple interest: you pay £500 a year, however long the loan runs.
Compound interest is charged on the amount borrowed plus any interest that has been added to it. It only makes a difference if interest is left unpaid and capitalised (rolled up into the debt). Many business loans require interest to be paid at the end of each interest period, monthly or quarterly, so in practice nothing compounds unless a payment is missed. Others, such as some bridging and development loans, roll interest up until the end. If your loan capitalises interest, check how often it does so. More frequent compounding means a higher effective cost for the same headline rate.
Fixed and variable rates
A fixed rate stays the same for the whole term or a set period. You know the cost in advance, but you won't benefit if rates fall, and repaying early may trigger break costs or an early repayment charge.
A variable rate moves with a reference rate, usually the Bank of England base rate or, for larger facilities, SONIA (the sterling overnight index average), plus a fixed margin. Check what the reference rate is, when changes take effect, whether there is a floor (commonly zero, so the reference rate is treated as never falling below it), and whether the lender can change the margin. A rate the lender can vary at its discretion is much riskier for the borrower than one tied to a published benchmark.
Default interest
Most loan agreements charge a higher rate on amounts not paid when due. That is generally enforceable in a commercial loan, but a default interest clause must not be a penalty. The courts ask whether the provision imposes a detriment on the borrower out of all proportion to the lender's legitimate interest in being paid on time. A modest uplift, applied only to the overdue amount and only for as long as it stays unpaid, is usually defensible, because a borrower in default is a greater credit risk. A large uplift, or one applied to the whole loan balance because of a small missed payment, is more open to challenge.
Also check whether default interest compounds, and whether a minor or technical breach (such as a late information report) can trigger it, or only non-payment.
Fees and the real cost
Arrangement fees, commitment fees on undrawn amounts, exit fees, monitoring fees and the lender's legal costs can add considerably to the cost of borrowing. For consumer credit, lenders must disclose an annual percentage rate of charge (APR) that includes most of these costs, which makes comparison easier. Business lenders usually don't have to, so work out the total cost yourself: add up the interest and all fees you will pay over the expected life of the loan, including any early repayment charges if you might refinance.
When consumer credit rules apply
Lending to a limited company is not regulated under the Consumer Credit Act 1974. Lending to an individual can be, including to a sole trader or a small partnership, unless an exemption applies. Some business-purpose loans to individuals above a set amount are exempt, as are some loans secured on land, which fall under the separate mortgage regime. If a loan is a regulated credit agreement, the lender must be authorised by the Financial Conduct Authority, the agreement must meet detailed rules on form, content and pre-contract information, and failing to comply can make it unenforceable without a court order. The courts also have power to reopen a credit relationship with an individual borrower that is unfair.
If you are an individual lending or borrowing, including between friends or family, or if you aren't sure whether a loan is regulated, take specialist advice before the money changes hands. Getting this wrong can leave a lender unable to enforce the loan.
Late payment interest on trade debts
The Late Payment of Commercial Debts (Interest) Act 1998 gives a statutory right to interest on late payment for goods and services between businesses. It doesn't govern interest on loans, which depends on what the loan agreement says.
When to get advice
Most business borrowers can work through a straightforward term loan themselves with the points above in mind. It is worth getting specialist advice where the loan is to or from an individual, where your home is being used as security, where interest rolls up over a long term, where there are interest rate hedging arrangements attached to the loan, or where the default interest and fees look high relative to the amount borrowed.
If you want to see how a loan agreement's interest, fees and default terms are analysed before you sign, you can see a sample report from QuickLegalCheck.
Related: what the loan agreement review covers, and a complete sample report.