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With interest rates so low, many lenders are finding other ways to profit from loans.
By Mark E. Battersby
Recently the Federal Reserve announced plans to pump up to $40 billion a month into the economy. While the Fed plans to purchase mortgage-backed securities, the strategy may make more money available for specialty fabric products businesses. Unfortunately, with interest rates so low, the only way many lenders can profit from small business lending involves fees. The all-important question: how much does that borrowed money cost?
Often, the interest rate stated by lenders does not reflect the true cost of a business loan. The loan agreement may specify that the borrower must maintain compensating balances, pay a commitment fee, or the loan may be discounted. These are only the more frequently encountered terms.
Discounted loans: When a loan is discounted, the interest is subtracted from the total amount of the loan. The proceeds received by a borrower, and available for use, represent the difference between the face amount of the loan and the stated interest. Discounted loans are usually short-term loans. For example, assume the stated interest rate on the loan is 12 percent, the face amount of the loan is $100,000, and the term is one year. The total interest (12 percent of $100,000 for one year) is $12,000. Since the interest is paid up front, this yields $88,000 of funds available for use. The effective interest rate is computed:
Interest/Net proceeds = Effective interest rate
$12,000/$88,000 = 13.64 percent
If the maturity of the loan is less than a full year, an adjustment must be made for the shorter term.
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. But the borrower pays interest on the entire loan. Assume a $100,000 loan, term of one year, and an interest rate of 12 percent. The compensating balance requirement is 15 percent of the loan. While $100,000 is borrowed, and interest paid on $100,000, the amount available for use is actually only $85,000 ($100,000 less 15 percent). The effective interest rate is computed:
Interest/Net proceeds = Effective interest rate
$12,000/$85,000 = 14.12 percent
Doubling up: Surprisingly, a shop could have a loan that is subject to both requirements; that is, the loan could be both discounted and compensating balances required. Using the previous numbers, the funds available would be reduced by the $12,000 interest paid up front and the $15,000 compensating balance. The formula is the same, but the net proceeds available are only $73,000 ($100,000 less $12,000 up-front interest payment, less $15,000 compensating balance). Dividing the $12,000 interest by the $73,000 in proceeds results in an effective interest rate of 16.44 percent.
Commitment fees: In some cases, a so-called “commitment” fee is charged by a lender, to compensate the bank or other lender for standing by and having the money available to lend. Typically the fee may be 1 percent of the amount not taken down or borrowed. For example, a borrower may need as much as $100,000 during the coming year. Currently, however, only $70,000 is needed. If the business borrows the full $100,000, it will pay 12 percent interest on the total. If only $70,000 is borrowed, the interest will be $8,400 (12 percent of $70,000). However, the borrower will have to pay a 1 percent commitment fee on the $30,000 not taken down. That’s a $300 annual charge for the right to borrow an additional $30,000 should it eventually be needed.
To compute the true interest rate on the amount borrowed ($70,000), the commitment fee must be added to the interest charge and the fee subtracted from the loan proceeds (since the fee is paid up front). The effective interest rate is computed:
(Interest cost + Commitment fee)/(Amount drawn down—Commitment fee) = Effective interest rate
($8,400 + $300)/($70,000 —$300) = 12.48 percent
The commitment fee can be assessed in combination with either a discounted loan and/or a compensating balance requirement. When calculating the combined effect of these terms, reduce the amount of the loan proceeds available for use and increase the interest cost by the amount of any special charges.
And more fees …
Let’s face it: lenders are business people. They’re in the business of making money. They provide a valuable service, and they charge for it. How reasonable those charges are will always be debatable.
Some other fees and charges associated with loans include:
Packaging fee: When you apply for a loan, you’re required to provide a lot of information about yourself, your business and your finances, backed by appropriate documentation. If you receive assistance from a third party (or the lender) in completing the loan application, there could be a charge for it.
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Processing/application fee: As part of underwriting, there is a credit check of both the owners and the business, and possibly also a personal background check. All this information is gathered and processed by lenders to make sure that the application package has the information necessary to analyze the probability that the loan will be repaid in a timely manner. The processing fee compensates the lender for the time, work and expertise required to complete this stage.
Underwriting fees: Once a loan application package is complete, it usually goes to the lender’s underwriting department, where a person or a committee studies it, verifies that all the information provided is true, assesses the risk the lender would be taking and approves or denies the application.
Closing costs: Closing costs are usually associated with mortgage loans and can include (but are not limited to) expenses such as attorney fees, title search and realtor fees. If a business loan includes a real estate transaction, the lender will certainly incur closing costs. Sometimes these are absorbed by the lender or the seller of the property to encourage the sale.
Maintenance or servicing fees: The lender may charge these fees on an ongoing basis (monthly or quarterly) to service a loan: handling payments, sending out notices and responding to inquiries, for example. There is also a fee unique to U.S. Small Business Administration (SBA) programs.
SBA Guaranty Fee: When an SBA loan is granted, the borrower usually reimburses the fee the lender is required to pay to the SBA. Think of this fee as “points” based on a percentage of the amount of the guaranty that the SBA is providing. Fortunately, the fee can be financed, allowing the borrower to add it to the principal amount to be repaid, substantially reducing its impact.
Lost opportunity costs
Before shying away from the high cost of financing where financing is available, remember that there are also costs associated with not borrowing. Consider the 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 investments. Today’s low interest rates might substantially reduce that lost opportunity cost, but it remains a factor to be considered.
Another frequently overlooked cost to not borrowing is that the business may stagnate, be forced to pass up growth opportunities or be left in the dust by expanding, modernizing competitors or those better able to finance increased efficiency.
Whether already available or more readily available, thanks to the Federal Reserve’s pumping more funds into the marketplace, business loans can and will vary by lender and amount. Shopping around to find a willing—and affordable—lender involves looking at more than the interest rate.
Due to the recent uncertainty of state and federal tax rates, along with health care costs, many businesses have taken a “wait and see” approach when it comes to decisions about expansion, acquisitions and financing. But with higher interest rates and inflation on the horizon, everyone needs to consider both the cost of borrowing and the costs of inaction.