Resources | Finance and Lending | December 12, 2023

The Cost of Money: What’s the True Cost of Borrowing?

If you’re comparing business financing products, several factors contribute to the true cost of borrowing — and they’re not just interest rates.

If you’re comparing business financing products, several factors contribute to the true cost of borrowing — not just interest rates.

Borrowing money is a reality for most growing small to midsize businesses. Nearly half of businesses use funds for expansion, with a majority of small business owners securing funds from banks, online lenders and financing companies. According to the most recent Federal Reserve data, the average small business loan is around $663,000.

If you’re seeking financing for your business, it’s important to first assess the true cost of borrowing for whichever financing product you choose. This helps provide an accurate picture of your debt obligations over the term of the loan and illuminates conditions that could affect your future growth plans. When measuring the cost of money, it’s smart to examine direct expenses such as interest rates, as well as the time, resources and opportunity costs associated with the funding.

While exploring business financing options and comparing costs, here are four key cost areas to consider.

1. Interest rates

The interest rate is the most obvious cost consideration when comparing funding options. Rates depend on market conditions, your financial situation and history, as well as the type of lender you choose.

It’s generally easier to predict interest costs if you’re using fixed rates, which are consistent throughout the loan term. Variable or floating interest rates, which fluctuate based on economic activity, can be more competitive at the start of your term. However, they’re harder to predict when evaluating the cost of money over time.

Borrowing rates are typically expressed as an annualized percentage rate (APR), which indicates the yearly cost of funds. The APR simplifies cost comparison when exploring different financing products. Remember that this rate includes both interest as well as any associated fees.

2. Fees and penalties

If you apply for a business loan from a bank, there will most likely be fees involved in addition to the interest rate. Many lenders charge:

  • Origination and administration fees to process loan applications and complete underwriting.
  • Appraisal fees for business loans that are secured against your assets.
  • Annual fees, which are charged to maintain the loan account.
  • Payment processing fees for wire transfers and checks.
  • Transfer and draw fees for moving your loan balance between accounts.
  • Overdue payment fees.

Most lenders will also charge penalties for prepayments. This is because paying your loan ahead of schedule shortens the loan term and effectively lowers accumulated interest for the lender. For example, US Small Business Administration (SBA) loans have annual penalties if you pay off 25% or more of the loan in its first three years.

3. Loan terms and size

Larger loans typically take longer to pay off and have higher interest rates and fees, resulting in a higher cost of money. One way to illustrate the cost impact of a loan’s term is by comparing the total borrowing expense on the same loan over different term lengths. The following example uses a $500,000 loan with a 10% APR that is paid off over three, five and 10 years:

$500,000 Loan, 10% APRassumes interest compounds daily
Loan termMonthly paymentTotal interestTotal payment
3 Years$16,133.59$80,809.37$580,809.37
5 Years$10,623.52$137,411.34$637,411.34
10 Years$6,607.54$292,904.42$792,904.42

Even with the same loan amount and APR, the total cost of borrowing increases significantly as the loan term lengthens. This is why it’s wise to accept only the amount of funding you need, even if you qualify for more. To reduce interest costs further, you can negotiate terms that enable you to make the highest monthly payments possible within your means.

4. Covenants and other indirect costs

It’s crucial that you gauge the indirect cost of money — the time and resources required to meet your financing obligations, as well as the cost of adhering to loan covenants. Loan covenants are credit agreements that restrict your business behaviors. Breaking these covenants puts you into technical default, which could prompt a lender to request accelerated loan payments. Some examples of covenants include constraints over:

  • How you can spend borrowed money.
  • Your working capital balances.
  • Mergers and acquisitions.
  • Salary increases and dividend payments to shareholders.

Many covenants will also require you to complete quarterly or monthly financial reports, which can be a significant time commitment and mean added costs if you hire a certified professional accountant to complete them. Covenant-mandated reports usually must show that you are maintaining certain financial ratios, including your debt-to-asset and debt-to-equity ratios:

Debt-to-Asset RatioDebt-to-Equity Ratio
= Total liabilities / Total assets= Total liabilities / Total shareholder equity
Indicates your business’s capacity to cover its debts with its assets, with higher values considered riskier.Depending on your industry, aim for a ratio between 0.3 and 0.6.Indicates the primary source of your business’s funding, with higher values considered riskier.Depending on your industry, aim for a ratio between 1 and 1.5.

These restrictions could have serious nonfinancial costs, especially if you plan on gaining equity investment or selling your business, or you have shareholders to satisfy. Additional factors, such as subordination agreements and personal guarantees, are as important as interest rates when evaluating the true cost of borrowing. Remember that acquiring too much debt also reflects poorly on financial assessments from analysts and investors.

Exploring your business funding options

Borrowing funds is a common way to access capital. However, many businesses also use debt-free solutions such as dynamic discounting and early payment programs, which allow you to offer invoice discounts to buyers in exchange for early payments.

Unlike business loans, these programs can accelerate your cash flow without any interest, fees or penalties needed to participate aside from the discount cost itself. They also don’t have the indirect costs of covenants or other restrictions that can affect your business operations.

The bottom line about the cost of money

By some definitions, interest is the main determinant of the cost of money for your business. A more accurate assessment weighs direct financial commitments, such as interest, fees and loan terms, with indirect trade-offs, such as covenants and any impacts on your growth plans. While borrowing funds may be necessary to support your business’s growth, early payment programs are usually a worthwhile alternative or complement to traditional financing sources.

Click here to learn more about C2FO’s Early Pay solution as a cost-effective alternative to traditional business financing.

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