How to Compare Business Loan Interest Rates
Knowing the true cost of a business loan is complicated, see how you can be fully informed so you can truly compare apples with apples.
What’s the rate, mate?
It’s a good question. What rate of interest are you being asked to pay on your loan. Small businesses have a wide variety of products marketed to them daily, with different features (secured, unsecured, line of credit), different interest structures (simple interest, compounding interest, discount factors), and different fees (documentation fees, draw down fees, early prepayment fees). The list goes on.
Small businesses are given confusing (at best) and/or misleading information about the true cost of loans in the market.
A small business has the right to compare products, but where one lender uses the term ‘interest multiplier’, another lender uses the term ‘discount factor ‘ and the third uses ‘payback amount’, the task is verging on impossible. What is wrong with the good old Annualised Percentage Rate (“APR”), which measures the loan costs over a comparable 1 year time horizon, as a common basis to compare competing loan products.
To illustrate the point, some lenders will market an interest rate being a percentage of notional. But be very clear, this is NOT an APR.
For example, if you borrow $10,000 today and repay $11,000 back in 1 year, then the APR is 10%. Simple. But what if you borrow $10,000 today and pay it back in half a year (APR is 20%) or in 3 months (APR 40%), or 1 month (APR 120%).
Some lenders will say, in each of these scenarios, the “Interest Rate” is 10%. The APR in these scenarios are very different, as is the true cost to the business, so make sure you understand what ‘rate’ the lender is marketing.
Also, be aware of the effect of periodic principal repayments (like a mortgage) – principal repayments need to be factored into the APR. For example:
Our $10,000 loan above, with principal and $1,000 interest paid at the end of year 1, is a 10% APR. However, if the $10,000 loan has monthly repayments of principal (such that at the half year mark, half the loan principal has been repaid, and on the 12th monthly repayment, the loan has been paid out), then $1,000 interest on this $10,000 loan is actually 20% APR. Ie. the borrower has not had the benefit of $10,000 for the whole year, but on average, only half a year. The faster the loan is paid down, the higher the APR.
So, some tips to help you compare across products and ask the right questions:
- Is the rate being marketed an APR or a percentage of notional?
- If the product has a discount factor, ask yourself what is the expected time until repayment; factor this into the APR calculation
- If the loan has principal prepayments, this needs to go into the APR calculation
- If there are fees and charges, feed them into the APR as well (who cares if they are termed fees or interest – it is still money and it still costs your business!)
- Check the terms around early repayment of principal – if early prepayment means you have to pay out future interest, then the APR has just skyrocketed (ie. you are being penalised for repaying early)
- Any lender who responds to the question with “we don’t charge interest, we charge fees”, is either trying to avoid giving a straight answer, or they don’t know the answer.
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Article courtesy of Moula Money Pty Ltd