Understanding the Cost of your Loan
Loans can be a frightening topic. As a business owner used to making tough choices, you understand this better than most: making a bad choice can be costly. We’ve written this article to help you better understand and navigate your way through the loan process by helping you better understand the cost of financing.
First, it is important to understand that the cost of financing depends on many factors including credit score, years in business, financing amount, speed of funding, term of the loan, business revenue, lender, and type of loan. Determining how to best leverage those factors to minimize the cost of your loan while finding a loan product that adequately meets your needs can be difficult and complicated. Here at Lendio, we have partnerships, software, and customer success teams to help you navigate. But even when given the best loan options, it is necessary to understand the cost for your business planning needs.
Loans can be broken down and explained in many ways, and while this might feel overwhelming, it does provide us many options for understanding the cost of a loan. Here are a few:
- Nominal Interest Rate is the interest rate for the term of the loan, applied at the end of each compounding period. A loan with a 6-month term at 12% nominal rate compounded monthly, would charge 2% interest on each month’s balance.
- Effective APR considers not only the impact of compounding, but also the loan fees. All the costs are then annualized. A $1,000, 6-month loan with a 12% nominal interest rate and a $100 origination fee would have a 35.2% effective annualized percentage rate (APR).
- Factor Rate/Buy Back Rate is the multiplier for the total payback on the loan. A 12% nominal interest rate on a 6-month loan (assuming no other costs) will produce a 1.12-factor rate. Factor rate does not consider the effect of compounding and assumes you will pay all the interest and fees in a lump sum at the end of the loan.
- Total Payback Amount considers the interest and fees of the loan as well as the principal balance. It is the total amount to be paid back over the life of the loan.
- Timing of Payments is the schedule of when the borrower is to remit interest and principal payments. Many lenders set-up automatic withdrawals on daily, weekly, or monthly basis.
- Term of the Loan is the length of time before the borrower is to have paid back the entirety of the loan. Many lenders will allow borrowers to renew loans as they near the end of their term.
We need to understand the relationship between these different expressions to avoid making a bad business financing decision. I will illustrate with an example. Consider a business owner looking for short-term working capital to meet a sudden spike in inventory demand. The business owner is then presented with the following two loan options (let’s assume for now that the time to get funded under each loan is the same – a bad assumption in the real world!):
First, notice how the second loan has a much lower effective APR. APR is used in many industries to standardize the cost of capital in order to allow borrowers to compare different loans. However, as this example helps illustrate, APR can also hide the true structure of a loan. If the business owner was presented with the two options above but only given APR and Loan Term as data points, the borrower, would likely be wary of accepting loan #1 even though it has less than half the Total Dollar Cost and fits better the situation in which they plan to use the loan. While APR was supposed to make the two loans comparable, it instead clouded the use and total cost of the loan.
MAYBE SHARE A FINDING OR TWO FROM OUR RECENT COST OF CAPITAL SURVEY HERE.
With this basic understanding, we hope that you can approach the loan process with the right questions in mind. Some information you should seek at a minimum for each loan include:
- Term of the loan
- Fees or prepayment penalties
- Total payback amount over the life of the loan
- Payment schedule (including due dates and payment amounts)