When considering a business loan to finance your capital needs, you’ll no doubt encounter a number of funding options. There are several types of loan options that provide business owners with cash quickly to help them meet a short-term need for capital, but there are a number of elements you need to examine to better understand the true cost of capital.
What to look out for when seeking a business loan
Annual percentage rate
Naturally, one of the first things you look at is the interest rate. And you shouldn’t just look at the monthly or annual nominal interest-rate, but the APR, or annual percentage rate.
The APR represents the true cost of a loan: it includes the basic interest rate, sometimes quoted monthly, as well as any fees you’re charged to set up or maintain the loan. The APR doesn’t include any late fees, but as long as you think you’ll be able to pay off your loan on time, you don’t need to include this in the total cost of a loan.
Time value of money (TVM)
Another key element to consider is the TVM, or time value of money. This is a complicated way of considering how much a dollar today will be worth in, say, ten years. You may often see economic figures that are “adjusted for inflation,” which means that the TVM is taken into account looking into the past. But you also need to know the TVM of your loan, and your capital, as you project for the future.
Understanding how much your capital costs for a business loan
It’s important to understand the above concepts – the true cost of capital – when comparing financing options for a business loan. Below we’ll take a look at two examples that can help you better understand how much your capital costs.
Let’s say you want to buy an item that costs $1, and you look for a loan to pay for it. If Lender A tells you, “If I lend you $1 today, you must pay me back $1.10 in two months,” and Lender B says, “If I lend you $1 today, you must pay me back $1.15 in 12 months,” which one is more expensive?
You might think that Lender A’s offer is better; after all, you’re only paying 10 cents in interest, compared to the 15 cents that Lender B is asking. But when you factor in the amount of time over which you are paying back the money, it’s a different story.
Lender A is charging you 10 cents for their loan, or 10% of the principal, but you have to pay it back in two months. If we look at how much this lender is charging over time, through compounding, we get the following:
(1+0.1) ^ 6 – 1 = 77%
We don’t need to calculate an annual rate for Lender B, because they have quoted you a cost based on a 12-month period. So you can see that Lender A costs you 77% on an annual basis, whereas Lender B only costs 15%. So which one is more expensive?
What’s important here is to compare apples to apples, hence the conversion of Lender A’s offer to an annual interest rate. However, 10 cents in interest over two months and 15 cents over 12 months are not directly comparable, because they are not measured on the same time horizon; they don’t present the same time value of money.
Let’s look at a more complex example.
What if Lender A says, “I’ll give you $100 if you pay me back $15 every month for the next 12 months,” and Lender B’s conditions are, “I’ll give you $100 if you pay me a lump sum of $180 in 12 months.” Which one of these is more expensive?
On the surface, both of these look the same, because in each case you pay back the same amount ($15 * 12 = $180), and because both are based on a 12-month time period. Right?
Not at all. If you again apply the *time* component to each of these scenarios, you’ll see that Lender A is getting their interest faster because you pay off your loan monthly, whereas Lender B only gets their full payment at the end of the 12-month term. If you run the numbers in Excel, you can see the difference:
To arrive at these numbers, you can use the IRR function in Excel, and multiply by 12 to view the interest rate on an annualized basis. (If you’re not familiar with the IRR/NPV functions in Excel, use our Cost of Capital Calculator.)
Questions to ask when comparing loans
To sum up, when you are comparing loan options for funding a company, a car, or anything else, you need to consider the following:
How much is the total interest to be paid back on the loan?
What is the *term* of the loan; how long is the repayment period?
How much is each payment, and what is the frequency of payments?
Once you have all three of these data points, you can use Excel’s IRR function to compare the actual cost of capital across different options.
Some lenders may require you to repay their loans weekly, or even daily, and this could drain your operating cash fairly quickly. They do this to speed up your payback period, and shorten the term; and, while this can look inexpensive, because the interest rate they’re quoting seems low, when you look closely you can see that this type of loan can be much more expensive than other loans. You might struggle to generate enough cash flow on a daily or weekly basis – especially if your revenue is irregular – to service their debt in a very short time, which means that you’re paying a very high cost of capital.
Interest rates can seem confusing, but if you compare loans on an equal footing, it is quickly obvious how much they cost and which is a better deal. With a few simple data points and a spreadsheet, you can make sure that you’re choosing the right option for your financing.
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