The first question most prospective borrowers ask me when they’re inquiring about a loan is “what’s the interest rate?” I always find what happens next to be quite curious and interesting. I politely answer their question, then pause for a moment to wait for the next, more important question—one that never seems to come: “What will my total cost of borrowing be?”
For some reason, borrowers almost never ask this critical follow-up question. More often than not, they shop around for loans using interest rates as the way to compare various lenders’ offers. Lenders know this and use it to their advantage by burying fees and other costs through the structure of the loan so they can compete on interest rates.
Based on my experience in helping companies secure financing, here are the 7 key aspects of a business loan that, together with the interest rate, form the true cost of a loan. When looking to borrow money, it’s important that you understand these additional costs. Once you factor them in, often you’ll find that the loan with the lower headline interest rate is not in fact the lower-cost option.
Due Diligence Costs
Diligence can be as simple as pulling a credit report and signing a pre-packaged loan agreement or as in-depth as conducting an appraisal of your assets, audit of your financial position or detailed review of your business. There are generally three types of costs associated with due diligence: time, legal and disbursements. Before agreeing to a lender conducting due diligence, understand who is responsible for covering each of these costs and how much these costs could be, and agree on a cap for each cost category.
Often lenders charge a monthly fee to cover the costs of administering and monitoring the loan. They charge this fee even if you don’t have any loan amount outstanding that month. A typical fee is between $50 and $100 per month on a loan of less than $250,000, but it can quickly escalate to several hundred dollars on larger loans. Most lenders will also charge an annual review or renewal fee.
The Loan Term
You may pay a lower headline interest rate on a loan with a longer term. But if that loan carries hefty pre-payment penalties or termination fees, or if you’re forced to keep the loan outstanding for longer than you need it, it may end up costing you more overall. A $100,000 loan at an annual interest rate of 12% (or 1% per month) with a one-year commitment will cost $12,000 in interest. However, if you only needed the loan for three months, you could have taken a loan at a higher rate (for instance, personal asset lenders charge 2.9% per month) and actually saved money. If you had done so, you’d have paid only $8,700 in interest, a savings of $3,300 or 28%.
Some lenders round up the loan disbursement amount to a set increment. For example, if the minimum disbursement amount is $50,000 and you need to borrow $50,500 that month, you will be charged interest on $100,000. If you can’t negotiate away any minimums, try to make the minimum amount as low as possible.
Monthly (or Annual) Minimums
Often lenders will require clients to have at least a pre-determined dollar amount outstanding on a monthly basis in order to get the advertised interest rate. And they may charge a penalty if you drop below this amount throughout the month.
Some lenders call this an annual “true up.” They calculate what the annual interest earned should have been and then require the borrower to top it up if the actual amount earned by the end of the year was lower than the expected amount.
How does the lender advance you the funds each time you need them? Do they wire you the money, deposit the cash directly into your bank account, send you a cheque or load a pre-paid credit card? These logistical questions can have a big impact on the cost of borrowing, especially if you’re borrowing often.
Lenders can charge a transaction fee each time they advance you money, with the cost varying depending on the method used. Wiring funds can cost from $25 to $60 for the outbound wire, which gets passed on to you. And you’ll also have to pay $10 for the inbound wire, regardless of the amount wired.
Finally, there is also the opportunity cost to consider. Even if a given loan carries higher costs, being able to access the cash right away may make it a good deal if you have an immediate profitable use for that cash. Some alternative lenders are typically able to fund significantly more quickly than traditional lenders such as the banks, which may take weeks or even months to approve or reject a loan.
Steven Uster is the founder of Zillidy, an alternative finance company that provides personal asset loans secured using precious metals, diamonds, jewelry, watches and other luxury assets as collateral. He is also the founder of Eldridge Capital, which provides accounts receivable financing for Canadian companies.