How business loan interest is calculated

The two things interest depends on

Every interest calculation comes down to two variables: the rate and the balance it is charged on. The rate is the percentage cost of borrowing over a period. The balance is the amount of money you actually owe at the time the charge is applied. Get clear on both and most of the confusion around loan pricing disappears.

The critical insight is that the balance usually changes over the life of a loan. As you make repayments, the amount you owe falls. Whether interest is charged on the original amount or the current, reducing amount makes a large difference to the total you pay — even when the headline rate looks identical. That single distinction, covered next, is where many directors overpay without realising it.

Flat rate vs reducing balance

A flat rate charges interest on the full original loan amount for the entire term, regardless of how much you have repaid. A reducing-balance rate charges interest only on what you still owe, so the interest cost falls as the balance shrinks. The same percentage means very different money.

Take an illustrative £20,000 loan over one year at 10%. On a flat basis, interest is roughly £2,000 — 10% of the whole £20,000 — even though your average balance over the year is far lower. On a reducing-balance basis, you pay 10% only on the declining amount outstanding, so the true cost is materially less for the same headline figure.

Basis	Charged on	Effect
Flat rate	Original amount, whole term	Higher real cost; flatters the headline
Reducing balance	Amount still owed	Lower real cost; reflects what you owe

A flat rate of 10% can equate to an effective reducing-balance rate roughly double that. Always check which basis a quote uses before comparing.

Why APR matters more than the headline rate

Because rates can be quoted on different bases and bundled with fees, the headline percentage alone tells you little. APR — the annual percentage rate — exists to fix this. It expresses the cost of borrowing as a standardised yearly figure that folds in both interest and certain compulsory fees, so two offers can be compared on a like-for-like basis.

APR is most useful as a comparison tool between similar products of similar length. It is less intuitive for very short-term borrowing, where a modest cash cost can translate into a large-sounding annualised percentage simply because the term is brief. That is why, for short-term business finance, the total amount repayable in pounds is often the clearer measure. Use APR to rank like-for-like offers, and the cash total to understand what the borrowing genuinely costs you. Our guide on reading a loan offer shows where to find both figures.

Fixed vs variable interest

Interest can be fixed for the life of the loan or variable, meaning it moves with an underlying reference rate such as the Bank of England base rate. The choice affects certainty as much as cost.

A fixed rate gives you a known repayment every period, which makes budgeting and cash-flow forecasting straightforward — you know exactly what leaves the account and when. A variable rate may start lower but can rise (or fall) over the term, so your repayments are less predictable. For short-term working capital, fixed pricing is common precisely because directors value certainty over a brief, defined period. For longer commitments, the fixed-versus-variable decision is really a judgement about how much repayment certainty is worth to you against the possibility of paying more — or less — if rates move.

How to compare two offers fairly

To compare loans properly, strip out the marketing and line up four things side by side. First, the total amount repayable in pounds — the single most honest number. Second, the interest basis (flat or reducing balance), because it changes everything. Third, the APR, for a standardised like-for-like rank. Fourth, the fees, which can quietly add to the real cost — our fees guide breaks these down.

Then sanity-check the structure. Does early repayment reduce your interest, or are you charged for the full term regardless? A loan that lets you repay early and save interest is more flexible than one that does not. Reading these elements together — rather than fixating on a single headline percentage — is the difference between choosing the cheapest-looking loan and choosing the genuinely cheapest one. To apply, you can register here.