In this blog I’m going to tell you why looking at just interest rates is the wrong thing to do, help you cut through the jargon lenders will throw at you, and walk you through the 3 simple questions you need to ask to properly evaluate the right deals for your business.
But first, what are you actually comparing?
It is important to realise that when you are evaluating an interest rate, how good a deal you’re getting all depends on the variables that go along with it.
If we’re talking about 10% APR (annual percentage rate), it’s actually not a bad rate. You could expect to pay 5–20% APR for a loan at a major bank depending on your business profile, and upwards of 20% APR with an independent lender if your application is deemed high-risk.
Or maybe that quoted 10% is actually the monthly rate for a short-term loan designed to be used for a few weeks, in which case converting it to a (rather alarming) APR figure is utterly irrelevant.
So what are the questions you should ask yourself?
1. What is the total cost of finance?
The first step in navigating this complexity is simple — forget about the interest rate. The most helpful figure to know is the total cost of finance: in other words, the amount you’ll pay back on top of the principal amount borrowed over the life of the loan.
Many sites include indicative breakdowns and business loan calculators, which are an easy way to get an idea of the total cost. Let’s say you want to borrow £25,000 — using the ‘total cost of finance’ method can produce some surprising results:
£25,000 at 10% for 24 months will cost approximately £2,687 in interest. Meanwhile, the same £25,000 at 15% over a shorter term of 12 months will cost approximately £2,077 in interest — so although 15% might sound more expensive than 10%, the different terms make it £610 cheaper overall in this example.
The point is, the total cost of finance method shows us that comparing interest rates is only helpful with all other things being equal.
Truth is, if you compare only the interest rates advertised, you could waste money, or end up with a deal that isn’t the best fit, but by forecasting loan repayments you will be able to find the best terms for your business.
2. How much will your monthly repayments be?
As well as the total cost of finance, another important metric to use to compare loans is the monthly payment. In our example above, the 15% option is cheapest. However, it comes with a much higher monthly payment as a result of the shorter term — you’d be paying about £2,256 a month on average, compared to £1,154 for the longer-term option.
This demonstrates another crucial element of choosing the right loan for your business. In this example, it would be reasonable to decide to pay £610 more overall in return for almost halving the monthly payment and freeing up £1,102 every month.
The main takeaway from this is that while comparing interest rates will show you which deal could be cheaper overall, this doesn’t necessarily show you which rates would be better for your business, especially if you run a tight cash flow every month. By forecasting loan repayments you can easily see if your monthly repayments are manageable for your business.
3. Why do you need the loan?
Clearly, there’s more to all this than just cost, and the mathematically cheapest loan isn’t always the right choice. Perhaps for your business, the most important thing is a manageable monthly payment, and you’re prepared to accept a bigger total cost of finance in order to get it (and as we saw in the example above, the additional cost might not be that much when compared to the total amount borrowed).
Flexibility can also be key. If your business is seasonal, a fixed monthly payment may not be an appealing prospect, and you might choose a more expensive loan because it has variable monthly payments.
Some other products function more like overdrafts, where you have a pre-agreed limit that you can dip in and out of with weekly or even daily interest calculations — with these, the cost varies hugely depending on how you use it, and therefore the cost aspect of the decision may be secondary to the flexibility of having the funding line there in the first place.
How to choose the best option for your business
If you’re already using cash flow forecasting software like Float, you’re in a good position to understand your affordability. Once you’ve had a look at a few different loan options, you can add the monthly payments to your forecast to see how available cash levels change.
Try inputting a range of costs (as you should with any forecasting), and look at an optimistic, neutral and pessimistic projection of where your business is heading. If some of these loan scenarios leave you close to cash flow negative, think twice. How comfortable you are with your projected future will help you determine how good an option the loan is.
Another simple way to test your intuition is to use the total cost of finance, by asking yourself questions like “am I prepared to pay £2,077 to borrow £25,000 over the next year?”
Bear in mind that the lender will also look at your affordability and factor this into their decision — and their aim is to guarantee you can meet the payments every month. However, what the lender won’t consider is how much cash you have leftover for other projects — it’s up to you to work out how the monthly payment will affect the running of your business, and how to leave enough cash available for other projects.
It’s clear that the interest rate is just one aspect of a business loan, and it’s important to consider other factors like the total cost and the monthly payment to make your decision. You should also look into more flexible options and consider the lender’s terms carefully. The key point to take away: just because a loan is more expensive overall, it doesn’t mean it’s the wrong choice. Every business is different, and working out what works best for yours comes down to much more than just the headline interest rate.
Conrad Ford is Chief Executive of Funding Options, recently described by the Telegraph as “the matchmaking website for small businesses and lenders”. Funding Options has been selected by HM Treasury to help businesses find finance when they’re unsuccessful with the major banks, as part of the Bank Referral Scheme that launched in November 2016. @FundingOptions