How to calculate the real cost of a business loan
Friday, April 20, 2018/
Not all business loans are created equal. And trying to calculate the total cost of a loan can be mind-boggling, especially with hidden fees in the mix. There is a lot of confusion in the lending space, but there is an easier way. Here’s everything you need to know to help you accurately calculate the true cost of a business loan.
What’s in a loan?
Before calculating the loan, it’s important to understand all the moving parts and how they affect your loan. There are five components in your loan:
- Principal – the amount you’re borrowing
- Interest – the interest rate multiplied by the principal
- Term – the length of your loan
- Repayment frequency – how often repayments are made
- Fees/charges – often hidden or disguised
These five components combine for the basic ‘total cost’ of your loan – that is the amount you will pay back to the lender over the course of your loan.
Principal: How much can I borrow?
Each lender has their own set of criteria to evaluate whether and how much they are willing to lend – this is called underwriting. Lenders have different risk appetites too, but more risk is accompanied by a higher interest rate. The amount you’re approved for will depend on the lender, but will usually relate to the size of your business’ turnover. Higher monthly revenues will indicate to a lender that your business can sustain a larger loan size. Business performance will also impact this decision, and lenders will typically look at all sorts of factors – from credit score and debts, to the industry and age of your business.
What affects my interest rate?
Most lenders use risk-based pricing, whereby businesses who are assessed to be lower risk can access lower interest rates. Again, this is determined by a whole host of factors, from industry to business performance. The type of loan you take out impacts the interest rate too. Generally, a loan borrowed against an asset (called a secured loan) will have a lower interest rate than a loan without an asset as security (an unsecured business loan).
How does the term impact the total cost?
The term of your loan is how much time you have to pay back the loan. As a general rule, if you only need a quick injection of cash and can handle higher repayments, a shorter term will be fine. If you need lower repayments, you can increase the term to make it more manageable – just be aware that while the repayments are lower, there are more of them so the total cost of the loan will be greater.
And what about payment frequency?
Some loans will have daily payments, others will be weekly, fortnightly, or monthly. In most cases, the more frequent the repayments, the more expensive the overall cost of the loan. Business loans are usually repaid back in equal instalments – the principal and interest repayment amounts are averaged across the total number of repayments.
Beware of hidden fees
Remember how frustrating ATM fees were? Business loan fees can be worse. Not all lenders are created equal. When looking for a loan, it’s good to look for a lender who offers transparency. If you don’t you could find yourself tripped up by a lender that uses fees and miscellaneous charges to make more money from their loans. While one loan may boast a lower interest rate, once you calculate all the hidden fees and charges, it could mean it will end up costing much more than a fee-free loan with a slightly higher interest rate.
Here is a super helpful list of sneaky fees and charges some lenders use
- Establishment/Origination/Application Fee: Covers the cost of setting up the loan or account.
- Documentation Fee: Covers the the time spent preparing your loan documents.
- Direct Debit Fees: Charged every time a repayment transaction is made. This can add up to hundreds if you’re making daily repayments.
- Monthly Fees: Ongoing monthly fees for the management of your loan.
- Withdrawal Fees: A fee for every withdrawal. Common in Lines of Credit loans.
- Late Payment Fee: A common fee that is charged for late payments. Most lenders have some sort of late fee. There is usually a five-day grace period after the due date before this fee is levied.
- Early Repayment Fee: Many lenders will advertise that they don’t have any early repayment fees, however, you will still be charged the interest you would have paid over the life of the loan.
- Amendment Fees: Your lender may charge fees if you request changes to your loan agreement e.g. If you wanted to extend the loan period or decrease monthly payments.
Now you know what to look for in a loan, you can calculate the true cost of a business loan with eyes wide open. Remember the best type of business loan is one that is transparent, easy to understand, and one you can comfortably repay.