How to compare business loan interest rates
In Planning growth, Raising finance, Rapidly scaling - 3 months ago - 4 min
How to compare business loan interest rates
Guest Author: Funding Options
When choosing a business loan, it can be tempting to base your decision on headline interest rates alone – but there are other factors you should consider before making a decision. Here are a few ways you can choose the best loan for your business.
Total cost of finance
A simple way to compare different products is by looking at the total cost of finance. Put simply, this is what the loan costs on top of the principal amount lent.
Regardless of the method lenders use to calculate interest, many of them include business loan calculators and indicative breakdowns of the total cost. These numbers are often more useful for making a decision that the interest rate itself. For example:
Imagine you want to borrow £50,000 but you’re not sure whether you’d prefer a one year term or a two year term. You’ve got two indicative quotes from different lenders, and you’re trying to weigh up which is best.
The first product is a 24 month loan at 12%, and the second is a 12 month loan at 17%. Which is best?
£50,000 over 24 months at 12% will mean you repay £6,488 in interest, so the total cost of finance is £56,488. On the other hand, a shorter term of 12 months but a higher interest rate of 17% produces a total cost of £54,722.
So although 17% sounds more expensive than 12%, it actually works out cheaper overall in this example because of the shorter term. Total cost of finance is therefore a useful, and fairly simple, way of comparing your options. With these two examples, you could ask yourself questions like “am I willing to pay an extra £1,766 for having the loan over one more year?”
Although the overall cost is one factor in your decision making, it’s also important to think about the monthly payment. Continuing our example above, although the 17% option over 12 months is mathematically the cheapest, it comes with a much higher monthly payment of £4,560 versus £2,353.
In other words, although the total cost of the finance is £1,766 less, the monthly payment is £2,206 more – because you’re paying back a similar total amount in half the time. This is crucial to factor in, as inability to meet just one monthly payment could lead to default of your business. Businesses can also compare funding where repayments are interest-only or interest and principal paid back each month. A short term advantage of interest-only can be less repayment each month as you only pay the interest, but this will lead to a large repayment or refinancing at the end of the loan term.
Remember that the interest is only one variable, and the amount you borrow and the length of the loan are both just as important for determining the total cost. Or to put it another way, the interest rate only helps you compare loans if all the other factors are equal.
(All of the above calculations are based on our business loans calculator, which can help you run the numbers on a range of funding scenarios).
It is important to ensure that you are comparing equivalent rates. For example, you may be quoted a rate of 10%, but is this an annual interest rate (APR) or a monthly rate? On some facilities the full amount may not be drawn down at once, but will you be charged on the full amount regardless, pr potentially face other non drawn down fees. These issues arise when comparing different loan types which have their own distinct terminology, and businesses should look to understand the full costs of each to make a comparison.
When comparing loans, businesses should also consider any other fees that may be payable to the lender, such as an arrangement fee or any ongoing monitoring fees. These are payments made to a lender in addition to interest payments, so should be factored into the total loan costs. Other factors to consider include certain covenants that a business may have to abide by, or personal guarantees, or cross charges that may need to be agreed before money can be released.
So far, we’ve been using examples that are all fixed-term loans. But the market is full of flexible products, top-up options, and overdraft alternatives — all of which can vary hugely in cost depending on how you use them.
As a business owner, it’s tempting to seek the lowest cost. But it’s also worth considering your funding options as a whole, to identify the other factors, such as flexibility. You should also ask yourself difficult questions, for example “am I prepared to pay extra for more flexibility?”, because while one option might be mathematically cheapest, that doesn’t mean it’s right for your business and the current situation.
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Fundamentally, every business is different, and the headline interest rate only gets you so far in determining what the best loan is for your business.
If debt finance is not for you, read about other fundraising options in our latest articles. Or if you’re thinking about raising investment and want to understand your options, get some free guidance from one of our team today on 08081 722350 or drop us an email: G.Enquiries@uk.gt.com