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The real cost of borrowing

Small business lending has taken a significant blow over the past few years. Lower interest rates have translated into lenders being more selective. Fortunately, with many larger businesses reducing their borrowing needs, there is increased attention on small business lending.

Although often overlooked, two factors impact on how much a business loan will cost: the interest rate charged and the fees required before, during and after the loan process. These factors combine to create the annual percentage rate (APR), which is the real cost of the loan every year a balance remains.

In reality, it is the type of loan needed by a business that directly affects the interest rate charged. All too often the interest rate stated by lenders does not reflect the true cost of a loan. The loan agreement may require borrowers to maintain compensating balances and pay a number of fees.

Among the most common fees are:

Packaging: When applying for a loan, borrowers are usually required to provide a lot of information about their business, its finances, etc. all of which generally needs to be backed by a great deal of documentation.

Processing/application: Checking the credit of both the borrower and their business, as well as perhaps a personal background check, are often required. The processing fee compensates the lender for the time, work and expertise required to complete this analysis.

Underwriting: Once a loan application package is complete, it normally goes to the lender’s underwriting department, where it is studied to verify all information provided is true. The lender also assesses the risk it would be taking by approving or denying the application.

Closing costs: These are usually associated with mortgage loans and can include – but are not limited to – expenses such as attorney fees, title search, realtor fees, etc. If a loan includes a real estate transaction, the lender will certainly incur closing costs that may be absorbed by the lender or the seller in order to encourage the sale.

Maintenance or servicing: These are fees the lender may charge on an ongoing basis (monthly, quarterly) to service a loan, such as handling payments, sending out notices, responding to inquiries, etc.

SBA guaranty: When an SBA loan is granted, the borrower usually reimburses the fee the lender is required to pay to the SBA. Similar to points, this fee is based on a percentage of the amount of the guaranty that SBA is providing. Fortunately, the fee can be financed, allowing the borrower to add it to the principal amount to be repaid.

In addition to these potential fees, the loan agreement may require the borrowing shop to maintain “compensating balances,” pay a “commitment fee” or the loan may be “discounted.” And these are only the more frequently encountered terms:

Discounted loans: When a loan is discounted the interest is subtracted from the total loan amount. Thus, the proceeds received by a borrower, and available for use, represent the difference between the face amount of the loan and the amount actually available. Discounted loans are usually short-term loans.

Compensating balances: Similar to discounted loans because the bank requires the borrower to leave a portion of the loan in the bank, effectively reducing the amount of funds available for use. Of course, the borrower pays interest on the entire loan.

Doubling up: Surprisingly, a business could find itself subject to both requirements, that is, the loan could be both discounted and compensating balances required.

Insult to injury: The commitment fee can be assessed in combination with either a discounted loan and/or a compensating balance requirement. When calculating the combined effect remember to reduce the amount of the loan proceeds available for use and increase the interest cost by the amount of any special charges.

Before shying away from borrowing, every shop or business owner should remember that there are costs associated with not borrowing. One common misconception is that using savings and investments to finance needed purchases or to keep the business going, saves on finance costs.

Consider the shop owner who lends his or her own funds to the business. In this case, the cost, often called a “lost opportunity” cost, is the amount those same funds would have earned had they remained in savings or invested. Today’s low interest rates earned by savings might substantially reduce that lost opportunity cost, but it remains a factor for consideration.

Another, frequently overlooked cost to not borrowing is that the business may stagnate, be forced to pass up growth opportunities, and even be left in the dust by expanding, modernizing competitors, or those better able to finance increased efficiency.

Borrowing isn’t the only way to finance a business. In order to expand, grow or even exist, many shop owners find it necessary to tap a variety of financial resources, usually falling into two categories, debt and equity. “Debt” involves borrowing money to be repaid, plus interest, while “equity” involves raising money by selling interests in the business.

Which alternative is the most economical, debt or equity financing? According to a report issued by the Joint Committee on Taxation, “the after-tax effect of debt financing is more favorable than equity financing because of the deductibility of interest.” That’s right, when it comes to managing debt, the interest paid on borrowed funds - even with the TCJA’s business interest limited deduction – is deductible by a business borrower, while funds directed to equity investment are not.

Due to the recent uncertainty of state and federal tax rates, along with healthcare costs, many businesses have taken a wait and see approach when it comes to decisions about expansion, acquisitions, and financing. Now might be a good time for every shop owner to weigh the cost of borrowing against the benefits of the decision.

Obviously, taking out a business loan is a big step in today’s uncertain economic climate. However, by calculating the cost of all available loan options, every woodshop business owner will be in a position to make a smart borrowing decision that will help the business grow and prosper for years to come. 

This article originally appeared in the December 2019 issue.

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