Sometimes the best solution to save a small business swamped by crippling debts or a financial drought is an injection of fresh capital. Other times you just want to grow your company out of your stagnant condition by hiring new employees or investing in a larger marketing effort, but you lack the financial means to cover all the expenses. Whatever the reason may be, a business loan might provide your company with the oxygen it needs to breathe some fresh air, speed up its growth or get back on its feet.
However, when you’re looking for a loan, you must take your time and choose carefully. Finding the best deal possible is vital to avoid ending into a “debt trap” or paying more interests and fees than you can possibly afford. How can you extricate yourself out of this jungle of flat interest rates, APR quotes and debt service coverage ratio? This guide will help you through the complexities of requesting a business loans and, of course, finding the best deal for your company.
The Interest Rate
The first thing you should look for when choosing your loan is the interest rate. In simple terms, it is the lender’s profit expressed as a percentage of the amount of money borrowed to be charged every year. So, if you borrow $10,000 over one year at an interest rate of 12%, you owe the bank an additional nominal interest fee of $1,200 on top of the $10,000. Many credit cards offer initial interest-free periods of some months or years, meaning that your interest rate is 0% during this first phase. Does this look simple enough? Well, things are all but simple in practice, let’s see why.
The Annual Percentage Rate (APR)
The Annual Percentage Rate (APR) represents the total cost of a loan, including any other fee you incurred when you took the loan. This quantity can increase the amount of money owed each month substantially, so it’s vital to specifically request your lender to provide you with the APR and insight into any and all hidden fees.
For example, let’s say you took a mortgage for $120,000 with a 10% interest rate, meaning that your annual interest expenses will amount to $12,000 (with a monthly payment of $1,000). However, the bank also applied a 5% arrangement fee ($6,000), meaning that to calculate the APR you must add these costs to the original loan amount for a total of $126,000. The 10% interest fee is then used to compute a new annual payment of $12,600, to get an APR of 10.5%.
Factor Rate vs. Interest Rate
Many online lenders offer loans with factor rates instead of traditional interest rates to make them appear less expensive than they really are. A factor rate is expressed as a decimal figure rather than a percentage, usually ranging from 1.1 to 1.5. To understand how much you should pay back the lender, you must multiply the amount borrowed by the factor rate. So, for example, if you’re asking for a $30,000 loan at a factor rate of 1.3 for a 1-year term, you must repay a total of $39,000 ($30,000 x 1.3 = $39,000).
Although you may think you’re just paying a 30% interest rate ($9,000), the actual amount of money owed is much higher than with traditional interest rates (it is roughly equivalent to a 55% interest rate!). The problem lies with the fact that factor rates are calculated using the original amount of money borrowed. Interest rates, on the other hand, are calculated over and over again on the depreciated capital. With traditional interest rates, the amount of money owed goes down every time you pay something back. With factor rate-based loans, instead, paying off early won’t save you any money.
Can you afford it? The Debt Service Coverage Ratio (DSCR)
The best way to determine whether you cannot afford a given loan or not is to calculate your debt service coverage ratio (DSCR). Your DSCR is calculated as (Cash Flow / Loan Payment), and the higher it is, the higher your chances to be able to pay your debt back without issues. For example, if you earn a net average of $2,000 (expressed as sales minus expenditures), and your monthly loan payment is just $500, your DSCR is 4, a really healthy amount. As a rule of thumb, you should never request a loan with a DSCR lower than 1.5 to avoid unnecessary risks. Anything above 2, however, is reasonably safe.
To compare loans from different lenders, you need to understand all the info included in their headlines. There are a myriad of options available, but the more you’re informed, the easier you can spot the right loan tailored to your current financial situation.