Trade Secrets: How to Compare Business Loans

Posted by Boyd Pederson on January 5, 2018

Apples and oranges, chalk and cheese, butter and honey, grandmothers and toads - whatever idiom you choose to compare the incomparable, lenders make it very difficult to compare the cost of a loan.

If money were truly a perfect substitute, we would all select the best value (price/features/convenience) when choosing lenders. Instead, marketers have come up with a cornucopia of products each with their own unique, overlapping, and confusing ways to describe price and features.

Fortunately for Australian consumers, we are protected by the National Credit Code, which requires lenders to provide a clear, concise and standardised comparison rate.

Sadly, this is not the case for small businesses.

Navigating the myriad of lenders and the relative costs to borrow with each can seem as simple as pinning a tail on a donkey, blindfolded.

BSAB-dont-walk-around-blindfolded-when-it-comes-to-your-business-finance-560x315 (1).jpg

Combined with the challenge of accessing finance as one of Australia’s 2.2 million SME owners, you may find that unraveling the differences between lenders, products, features and costs is both time consuming and frustrating.

Access to finance impacts on your ability to effectively manage cash flow, invest in growth or new equipment or simply to become more competitive in your market.

Consequently, the top frustrations for small business owners (based on this focus group led survey) are

  • the inability to compare prices
  • a lack of transparency in features
  • no statement of penalty fees and clauses.

Securing finance is a challenge that has been recognised for some time by the Australian Government. In 2014, the Financial System Inquiry recommended a series of actions to reduce impediments and barriers to market-based funding.

Most recently, 2017 research undertaken by the Australian Small Business and Family Enterprise Ombudsman confirmed that many Australian SMEs were continuing to face financing constraints in access to bank and equity finance. This is in respect to both access and approvals as well as arrangements.

How do you best compare small business loans for your needs and how do you review your options? The secret is to understand how to select the financial product that will support improvement in your finances into the future.

It's not as tough as it looks, but you have to take the blindfold off.

Know your options

Small business financing falls into two broad classes:

  • Cash Advances– money advanced to you in return for the legal right to specific revenue streams. Lenders recover payment from you by taking fixed per cent of that future revenue.
  • Loans- money advanced to you without any specific claim on your assets(called unsecured lending) or against assets (typically property and equipment).

Option 1: cash advances

There are two main types of cash advance lenders:

Merchant Cash Advance

The funding company advances funds to the business.

The business pays back the advance and the agreed fee (total cost of funds) by paying some proportion of the business revenue stream which the funding company now has a legal right to.

The advance is paid back through a percentage of the total merchant cash terminal receipts (typically 5-20%) until the total cost of funds is completed. As long as the total cost of funds is fully repaid within the agreed time period, there are no additional charges.

Invoice finance

The funding company advances a percentage of a single or several invoices that the business has issued for work that has already been completed (typically 80% or less, but this can vary).

The business agrees to pledge the invoices to the funding company, and, when your customer makes good on the invoice, the advance and the cost of funds are deducted by the funder, and you are paid the remainder.

In both of these cases, the typical duration of funds outstanding to a business is less than 90 days, and the actual Annual Percentage Rate (APR) paid by the business is higher if the advance is paid back quicker.

APR is the annual rate that represents the actual yearly cost of funds over the life of a loan. This includes any fees or additional costs, takes into account compound interest and is sometimes referred to as a comparison rate.

Cash advance loan example costs

  • Amount borrowed: $30,000 for 3 months
  • Advertised rate: 3% per month
  • Fee: Included
  • Total Cost of Funds: $2,700
  • Total Cost of Funds over 12 months for comparison: $10,800
  • Comparison:
    • Simple interest = [$10,800/30,000] = 36%
    • The APR is a whopping 42.5%

Plan to repay early? APR would climb making it a more expensive loan.

Want to spread repayments over longer period? Not possible.

Option 2: business loans

As you can imagine, because loans have been around for a long time, many have developed unique features. The most common variations include

  • How the cost of funds (interest) is charged: on the advanced amount, or on a declining balance.
  • Whether interest is charged daily, weekly, or monthly.
  • The frequency of repayments (daily, weekly, monthly).
  • Whether the repayments include both principal & interest or are interest-only, with the original advance repaid at the end (often called a 'balloon payment').
  • How the lender gives you access to the funds (all up front - traditional loan or on-demand Line of credit).
  • Is security required? (ie. what do you potentially lose if you don’t repay?)
  • How fees (see below) are charged? Are they added to the loan value, or paid out-of-pocket?

And, there are a plethora of fees and penalties in the fine print that you need to be aware of. The most common of these are:

  • legal, documentation, and application fees (paid up front or added to loan to be paid overtime)
  • establishment fees (paid at time of disbursal)
  • draw down fees (paid each time you receive funds)
  • prepayment fees (penalty fees you pay if you want to repay early)
  • penalty fees, and penalty interest (paid if you miss one or more payments or otherwise default of the loan)

Example costs of a business loan with interest charged up front

  • Amount borrowed: $30,000 for 3 months
  • Advertised rate: 10% per annum
  • Fee: 2% of borrowed amount
  • Total Cost of Funds:$3,600
  • Total Cost of Funds over 12 months for comparison: $14,400
  • Comparison:
    • Simple interest = [$14,400/30,000] = 48%
    • The APR is over 86%

Plan to repay early?No impact on interest paid on loan. Beware of any fees charged for early repayments.

Want to spread repayments over a longer period?

  • 3 months APR: 86%
  • 12 months APR: 23%
  • 24 months APR: 12%

Example costs of a business loan with interest paid on outstanding balance

  • Amount borrowed: $30,000 for 3 months
  • Risk-based rate: 10% per annum
  • Fee: 2% of borrowed amount
  • Total Cost of Funds: ~$714
  • Total Cost of Funds over 12 months for comparison: $2,856
  • Comparison:
    • Simple interest = [$2,856/30,000] = 9.52%
    • APR is 25%

Plan to repay early? The sooner you repay, the less you pay in interest.

Want to spread repayments over a longer period?

  • 3 months APR: 25%
  • 12 months APR: 14%
  • 24 months APR: 12%

In summary

The secret is, there is no secret, you just have to ask the right questions and have a clear purpose in mind for why you need the loan to determine which lender and type of credit best meet your needs

  • Make sure you compare the full costs, including interest, transaction costs, potential penalties and fees over a full year.
  • Consider the various annual percentage rates.
  • Check the features of the loans, including flexibility.
  • Ensure the lenders you are considering offer clear guidelines and are transparent.

Smart borrowing isn’t about accumulating debt – it’s about using finance to leverage cash flow and ultimately your business growth.

For more information about your financing options check Bigstone’s loan calculator or contact us for a no-obligation consultation.

This article was originally published on 20/2/17,and updated on 5/1/18.

Download our free infographic 5 ways a business loan can help your business grow

Topics: borrower

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Boyd Pederson

About the Author

Boyd is an expert on small to medium business lending, distribution, operations and IT. ​He is a specialist in developing profitable growth strategies, driving operational performance improvement and building new capabilities and ventures.

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