13 Nov How Does Your Business Loan Stack Up? Know The True Costs
Understanding the cost of a business loan and how it compares to alternatives I’m sure is of interest to all owners.
In the world of commercial finance, figuring out the true cost to your business is often not as simple as you would expect. A level of transparency comes attached with consumer finance products with effective APR’s and comparison rates required to be disclosed by lenders, facilitating simplified comparison.
Commercial borrowers are not extended the same luxury and need to do a little bit of work to perform accurate comparisons. We’ll start with the bank overdraft, the first port of call for most business owners when looking for finance. Bank overdraft costs are typically expressed as an annual interest rate (compounded daily).
Importantly overdraft interest is normally calculated on the daily loan balance, just like your home loan and credit card and what you would expect. As the loans are commercial in nature banks are not required to disclose a comparison rate on overdrafts so be sure to understand the fees associated with the loan (both at setup and ongoing).
As an example consider the following overdraft loan offer:
Loan Amount: $25,000
Interest Rate: 10.5% pa compound interest
Account Open Fee: $500
Monthly Service Fee: $35
Effective Interest Rate: 12.7%
While generally easy to understand and compare, ongoing fees in particular, can quickly and materially affect the true cost of a bank overdraft. As overdrafts are generally the most transparent of all commercial loans, we will use it as the baseline for comparing two non-bank commercial loan types – Fixed Term Loan and Invoice Factoring.
Fixed Term Loan
Fixed term loans are a relatively new option for Australian businesses with high demand seen from borrowers who don’t qualify for bank finance. Traditionally fixed term lenders will not quote you an interest rate for the loan (you will understand why soon), instead they quote a factor rate.
A typical offer is stated as follows: $25,000 loan at a factor rate of 1.35 over 9 months. This means the business owner borrows $25,000 and pays back $33,750 (Loan Principle x Factor Rate) via weekly $865 repayments over a 9 month period.
Now how to convert this offer to an interest rate and compare this to the above bank overdraft… You may start by calculating the total interest paid ($8,750) as a percentage of the loan principle – 35%. You then may realise that the term was 9 months so you decide to annualise the rate, giving you something in the region of 46% pa. This value is not accurate for comparison purposes however.
The point to understand is that unlike a bank overdraft, traditionally for this loan type the repayments do not reduce interest owed. The payback amount is agreed and capitalised at inception, weekly repayments do not reduce interest paid over time. If you are handy with Excel then you can use the Internal Rate Return (IRR) formula to identify the effective APR which can then be used for comparison to the bank overdraft. For those that don’t, this online tool will quickly do it for you: https://www.lightercapital.com/widgets/WhatInterestRateAmIReallyPaying/. As you will see for the fixed term loan offer above equates to an effective APR is 127% and is the correct value to use when comparing to the bank overdraft costs. Little wonder effective APR’s on Fixed Term loan products are usually not disclosed.
Invoice factoring has been a viable funding option for B2B businesses for decades. The concept is simple – you present an invoice or batch of open invoices to a financier and they advance you capital. Understanding the true cost of an invoice factoring facility is not so simple with lack of cost transparency again a factor. Let’s look at single invoice finance, consider the following typical finance offer:
Invoice value: $40,000
Advance (loan) amount: $25,000
Discount Rate: 0.05% per day (18.25%pa simple interest)
Before you take the discount rate for comparison it’s important to realise that most financiers charge the discount rate on the face value of the invoice and not funds loaned. So we will adjust for that in our calculations:
Customer pay date: 45 days
Discount Paid: 2.25% (45 x 0.05%) = $900 (2.25% x $40,000)
Interest On Loan Amount: 3.6% over 45 days
Annualised Interest Rate: ~ 28.8%
For this offer 28.8% is the value to be used for comparison.
As demonstrated, a little bit of math is required (Excel is your friend) for business owners to understand fully how their business loan stacks up. At a minimum the business owner should ask themselves the following 3 questions to ensure they are comparing apples with apples:
- What are the applicable loan fees and their effect?
- Do loan repayments reduce the interest owed over time?
- Is loan interest calculated on funds borrowed or some other metric?
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