There are dozens of small business loan options and thousands of lenders. How are you supposed to know the true cost of your financing options, when lenders so often don't make it simple to understand? We'll provide some tips to help you understand the true cost of any options you're considering.
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Introduction: Business Loans and APR
As a small business, you might seek financing for a range of reasons. You might need money to expand, fill a temporary cash flow need, cover a sudden expense or buy needed equipment. When considering financing options, you’ll want to look at the total amount you need, the payback schedule and of course the costs.
Today, there are more options than ever, from bank and SBA loans, to fast working capital loans, to lines of credit, cash advances and equipment loans. Each type of financing has its own structure and its own fees, often making it really tough to understand the true cost of different financing options.
In most lending, including personal loans, credit cards and mortgages, people consider the cost of financing by looking at APR (Annual Percentage Rate). This is really useful when available, but many providers of business financing don’t publish an interest rate or APR. (This in itself is a topic for a whole separate article.)
Since APR is so often not available, some borrowers will use a simplified cost calculation like this: interest = (total amount repaid – total amount borrowed) / total amount borrowed. This approach is fairly simple but is unfortunately not an adequate approach.
Let’s take an example. Suppose your business gets a loan for $10,000, with a cost of $1,000, and you repay the $11,000 ($10,000 + $1,000) over 3 months. So, you paid back $1,000 compared to the $10,000 you borrowed. Is your interest just $1000/$10,000, or 10%? No, it’s not. When you annualize the cost, the true interest cost is actually closer to 80%! Startling, huh?! And this doesn’t include the cost of any loan fees that might be part of the financing.
Below are some tips for assessing the true cost of your small business financing.
Loan Amortization Schedule
When calculating interest for loans, and the way APR works, interest is not calculated on the amount you originally borrowed. Instead, interest is calculated on the amount outstanding at any given point in time. This outstanding amount is often called the “outstanding principal balance”.
So, for example, if you get a loan for $10,000 and pay it off over a year, the average amount of your outstanding balance during the year was roughly half, or $5,000. Why? Well, on day one you owe $10,000, and on the last day you owe $0. So, approximately, the average outstanding during the year was about half, or $5,000.
Think about it this way: once you’ve paid back some of the loan in the middle of the year, you shouldn’t be paying interest on the whole amount by then, right? The interest shouldn’t apply to what you’ve already paid back.
So, let’s use the example above. If you borrow $10,000 and pay back $11,000 over a full year ($1,000 in interest), your annualized interest equals around 20%. Why? This is because you paid $1,000 in interest on an average outstanding of about $5,000. The $1,000 / $5,000 is 20%. (Again, this isn’t an exact APR calculation, but it’s an easy, close estimate.)
Now, if you paid back the same $10,000 loan in six months, your annualized interest would be closer to 40%. This is because you paid the loan back in half the time (6 months), so to annualize the true interest cost you double the 20% calculated for paying off in a year.
Finally, let’s go back to a scenario where your business borrows $10,000, with a cost of $1,000, and pays back the entire $11,000 over three months. Now, your APR is approximately 80% APR. Your average outstanding principal balance was roughly $5,000 ($10,000 at the beginning of the loan period, $5,000 in the middle and $0 at the end.) So as a result, you paid $1,000 for an average of $5,000 for just three months, which is 1/4 of a year. The estimated APR here would be ($1,000 / $5,000) x 4 = 80%.
Loan Origination Fees
Sometimes, your business will pay a fee, or fees, at the time the loan is made. This is often called an origination fee, though some lenders instead charge a processing or underwriting fee. Origination fees are often calculated as a fixed percentage of the loan amount, though sometimes the fee is simply a fixed amount. This fee is typically deducted from the amount of the loan you receive.
Even small fees can dramatically impact the overall cost of business financing. Suppose your business borrows $10,000 to be paid back over 3 months, and assume the annualized interest on the financing is 20%. With this financing there is a 2% loan origination fee ($200). This means that your business only gets $9,800 when you take out the loan, since $200 will pay the fee.
With the fee, your effective annualized interest rate is not 20% any longer. With the fee, the annualized rate is actually closer to 36%! (The calculation: 20% + ($200/$4,900)*4. We use $4,900 in that equation because that’s the average of the outstanding balance during the three months, and we multiply by 4 to get the annualized cost.)
Your Time and Hassle
We have talked about the interest and fees that are part of small business financing. Another factor, though one many owners will overlook, is the cost of their time or their employees’ time spent in pursuing and securing financing.
In today’s world, there are literally thousands of lenders, so it’s usually in your best interest to spend time applying with multiple lenders to find the best fit for your needs. This requires filling out paperwork, submitting documents and conducting phone calls or interviews many times.
This application process can take a good bit of time, and this time has value. It is time that you as owner, or time that your employee, could have spent on other important business functions. For an employee, you can calculate the true cost of their time. For an owner, the calculation is a little harder.
Suppose the process of obtaining business financing takes three hours of your bookkeeper’s time, and assume they make $45/hour including benefits. This means that obtaining your financing actually cost your business an extra $135 ($45 x 3). On the $10,000 loan, where the interest was $1,000, an extra $135 is not an insignificant cost.
Even more expensive is the time contributed by the owner. Even if there is staff to handle much of the paperwork, the owner is often involved in finding appropriate lenders and having discussions with those lenders by phone and email.This can take many hours at a cost well above the hourly cost for any of the employees. (The time of the owner may be a good investment, however, if they are able to find an option that reduces the overall borrowing cost significantly.)
Owners can get the benefit of applying with many lenders while also minimizing their time investment by working with an experienced and trustworthy financing broker. A good broker will take over much of the work submitting applications and negotiating with lenders. This can help reduce the time the owner is away from the business, plus it can help ensure the best financing options are considered.
About the Author
Mike Spitalney is the CEO and founder of Everfund. Mike is on a mission to help small businesses get the best financing for their needs and avoid the confusion and complexity of today’s lending world. Over two decades, Mike and Everfund have helped thousands of businesses thrive and grow using a variety of short and long-term loan options, from working capital loans and lines of credit to SBA and bank loans and commercial mortgages. Outside work, you'll usually find Mike outside running, hiking or biking.