Understanding the Cost of a Loan
The borrowed amount plus interest will be the largest loan payments you’ll make, but not the only ones. Be informed to make the best decision.
Congratulations! Your business has reached the point where you need some extra capital to continue to grow, or you’ve decided to start a business and can use some financing to help you get going.
Either way, this is an exciting time filled with opportunity and promise. It can also be a bit overwhelming as you start to explore your options and are faced with decisions that will impact you for a long time to come. Finance terms can be confusing, and there is a lot to consider.
This article help you understand the various components of a loan, and how each will affect what your payments will be like. Not all loans will carry the same fees, but it’s good to be prepared, so let’s start at the beginning.
Application or Processing Fee
Depending on the type of loan you’re applying for, you may be charged a processing or application fee just to get started. Now, you may be saying, “Wait-they want to charge me before I even know if I’ll get the loan??” Well”¦yes. Think about it. A lot of work goes into figuring out whether you qualify.
The lender will run credit checks on both you and your business, and you may even require a background check. The lender has to arrange for these and then analyze the results to figure out the probability the loan will be repaid on time. The application fee helps compensate for the time, effort and expertise involved.
When you apply for a loan, you have to provide a lot of information: the application form, a business plan, tax returns, financial statements, accounts payables and receivables, and legal documents pertaining to your business. Someone at the lender needs to compile this package, verify that the information is true and complete, and determine the risk of extending you a loan. The underwriting fee is to offset the expenses involved with this part of the process.
Some lenders will charge this fee to cover any other miscellaneous costs involved with issuing your loan, including a payment to the broker or other individual who brought them the business. (You may be more familiar with the term “points”.) As opposed to fees for applying or processing, an origination fee is only charged when the loan is actually completed and approved.
If you are offering property as collateral for the loan, the lender needs to know what it’s worth. In most cases, an independent appraisal company will be hired to determine this, and you will be required to pay for it. You are entitled to a copy of the appraisal report.
Principal and Interest
Once the initial application and underwriting fees have been paid and you’ve been approved (yay!), your loan, itself, will have two main components: principal and interest. “Principal” is the amount you are borrowing, and “interest” is the percentage of that amount that you’re charged for the privilege. Interest rates are important because, other than the amount you are borrowing, nothing else will have as large an impact on your payments. So let’s dive in a little deeper.
What Determines How Much Interest I Will Pay?
Lenders use a lot of factors to determine interest rates. You have no doubt been hearing a lot about the Federal Reserve Board in relation to interest rates, and that is where much of it starts. The Fed sets various interest rates it charges to banks, and banks, in turn, use those rates to start figuring out what to charge you.
Other factors outside your control include inflation and supply and demand. Generally speaking, when inflation levels are high, interest rates are likely to be higher, as well. And when the demand for credit is high, interest rates are also more apt to rise.
Risk is a key factor that lenders will take into consideration. Some prefer very little exposure to it while others are more tolerant. One thing’s for sure: a risky investment will cost you more. Here are some ways the bank measures the risk of investing in you:
1. A High Credit Rating Can Lower Your Interest Rate
By far, the best thing you can do to help yourself is maintain an impeccable credit rating. Quite simply, the higher your score, the better the chance you’ll pay the loan back. The lender wants you as a customer, and will offer you the most competitive terms possible. Interest rates can vary by more than a percentage point depending on your credit score, and of course, may also mean the difference between being approved or denied in the first place.
2. Having a Secured Loan Can Lower Your Interest Rate
Along those same lines, if your loan is secured with collateral, whether it’s inventory or property, you will also usually get a lower rate than you would on an unsecured loan. If you stop making the payments you’re supposed to, the lender has something to fall back on to cut its losses.
3. A Shorter Loan Term Can Lower Your Interest Rate
The term, or how long the loan period is for, will also affect your interest rate. Statistically, longer-term loans have a greater chance of not being repaid, so they carry higher rates.
4. The Size of Your Loan Impacts Your Interest Rate
Your interest rate will also be determined by how much you borrow. Again, it all comes down to the lender’s risk of being paid back. The more borrowed, the greater the chance of default.
5. Your Reason for Borrowing Impacts Your Interest Rate
Finally, what you are borrowing the money for will also impact how much interest you’ll have to pay. Say you need the loan to expand your warehouse because your wildly successful business has to stock more goods. You can offer the existing building and inventory as collateral, and you have a proven track record. This bodes well for finding a very competitive rate compared to someone who needs the money to help make payroll or cover other operating expenses. Both are very valid reasons for needing a loan, but the latter will likely cost more.
In lending parlance, this fancy equation is known as the loan-to-value ratio. Basically, it’s a comparison between how much you are borrowing and the appraised value of your collateral, and it’s expressed as a percentage. For example, if you’d like to borrow $50,000 and have a building worth $100,000 to use as collateral, your loan-to-value ratio (LTV) is 50%.
Should I Get a Variable or Fixed Rate?
Generally speaking, there are two different types of rates. For one, the interest rate will stay the same during the term of the loan. This is called a “fixed rate”. The other, known as a “variable rate”, can fluctuate. You will always know which kind of loan you have, and if the rate is variable, you will be told how often it may change and how it will be calculated.
When interest rates are on the lower side, as they are now, it’s a smart idea to lock them in with a fixed rate loan. Variable or adjustable rate loans may be a good option when rates rise, as they usually start out at a lower level for the initial term. Just make sure you will be prepared to handle the payments when the higher interest rates kick in.
Monthly Service Charges
Some loans will carry small fees each month to cover the cost of sending out monthly statements, collecting payments, keeping records, following up on any late payments, and disbursing funds to the proper place. These charges for loan servicing are most common with loans for mortgages.
So, you got your loan and spent the money making the improvements you wanted to in your business, and they are already paying off. Awesome! Your first instinct might be to pay the loan off early or at least make larger payments than you have to in order to save yourself some interest. Think again. Or rather, first double check that it won’t cost you additional money to do so, as some lenders do include such a fee in the terms of the loan as another way of ensuring they make what they planned when they offered it to you. You may also see this called a make whole premium.
Alternately, you might see something called an exit fee, which is similar to a prepayment penalty but due any time a loan is paid off-even at its full maturity.
The government’s Small Business Administration has several loan programs available through various banks and other lenders. These loans are structured to meet strict requirements so they can be guaranteed by the SBA. Not everyone will qualify, and there are government guidelines for which fees may and may not be charged.
The Bottom Line
When it comes to applying for loans, the amount you are borrowing and the interest you are charged to borrow will be the two largest chunks of the payments you’ll make but not the only ones.
As with all major purchases, do your homework and be informed to make the best decision. You read this article, so you’re obviously well on your way!