Guide to Small Business Borrowing, Part 2
Overview Part Two
We continue from part one. Part One broke down what it takes to borrow, build business credit, how the approval and funding processes work. Part two will discuss the cost of borrowing, risks, terms and repayment structures.
Cost of borrowing: How much should I pay for a loan?
You’ll want to map out a business plan for comparing the costs of borrowing. It’s not all about interest rates and payment schedules. Cost-savings, tax deductibility, revenue generating or opportunity lost because of not borrowing must all be determined to truly understand the real cost of borrowing. Rate will be a determining factor as to how and how much you want to borrow, but should not be the only reason to borrow or not.
Short-Term vs. Long-Term Borrowing
Most businesses focus on the interest rate which is typically expressed as an Annual Percentage Rate (APR), a calculation of the interest rate for the entire year (amortized or annualized). APR doesn’t necessarily dictate the cost of borrowing but shows rate of capital. Interest rate alone doesn’t account for after tax deductions, and many other benefits of using other people’s money to generate revenue or save capital. APR can be useful however, when comparing our working capital loans and cash advance products. Comparing loans with different terms, for example, a $10,000 loan at a 17.5% APR, compounded monthly, will have a different total cost depending on term:
- 6 Month Loan: Total cost of $10,515
- 60 Month Loan: Total cost of $15,073
So, while APR may be a good measure of the annual cost of a loan, it isn’t always the most helpful figure if you’re trying to compare the costs of two loans. Would you borrow at a higher payback just for the sake of the term, or vice versa? Would you sacrifice revenue over rates? You must ask these questions to determine your true cost of borrowing.
Rate factor is basically the best and the oldest way to know your true costing of borrowing. Cents on the dollar is another framework to compare the total cost of a loan, regardless of term, fees, or annual percentage rates. It’s simple, proven and widespread: take the total amount you’d pay over the life of the loan (including fees) and divide that by the original funding amount. So, for the sample 17.5% APR loan sited above, your cents on the dollar cost would be 5.1 cents/dollar, and 50.7 cents/dollar, respectively. Notice that the shorter the term, the cheaper the loan is. But the interest rate will be higher on typical short-term unsecured loans.
Payment, Payback Structure
Fixed or Variable
Most Term Loans from banks have fixed payment terms and amounts because most bank loans are amortized. Amortization is the breakdown of balance, principal and finance charges, especially, for loans lasting longer than 1 year.
Most of our working capital programs have a term of less than a 1 year. Business credit products, such as cash advances, take a variable amount on any given day or month, often based on your credit card receivables. This introduces an element of risk, as it becomes harder to say how long you will have to be making payments.
Daily, Weekly or Monthly Payment
Different funding sources require that payments follow different schedules. Depending on a business’ cash flow, payments may be daily, weekly or monthly. Most payments are no longer being billed traditionally, and our financial protocol has now evolved into automatic debit via ACH, or taken out of your daily credit card batches to avoid late fees and tends to be beneficial during refinancing. Most merchants appreciate automated micro-payments, since they result in smaller deductions to lessen the impact of a short-term payback.
Terms: Longer term = higher risk for lenders.
Is the lender willing to take a higher risk? Are you willing to pay for this risk? When thinking about the term, it’s important to match your loan needs to the investment/risk lenders are taking. As a simple rule of thumb, long-term investments, with long-term returns, should be matched to long term loans. Any loan or loan product should be entirely paid off prior to starting a new round of purchasing in order to allow you the freedom to pursue additional financing.
Finally, keep in mind that the term of a loan is a tradeoff between risk and flexibility: a fixed-rate long term loan locks you in to rates, for better or worse, and may prevent you from pursuing other capital options for its duration. A short term loan allows you to rethink your financing strategy or pursue cheaper capital as it becomes available, but also exposes you to the risk that it may not be available.
About Liberty Capital Group, Inc.
Liberty Capital is a BBB Accredited business with an A+ rating. We are located in the heart of San Diego. Since 2004, we have watched the rollercoaster ride that banks, financial institutions, brokers and other funding sources have undergone. Many have subsequently folded. Liberty Capital has weathered these tough economic times. We have helped businesses stay open, worked out solutions to accommodate cashflow problems and have refinanced over 85% of our customers. Your success is our success!