The Real Cost of Borrowing Money
Before signing on the dotted line of the loan papers, you'll want to consider a variety of other monetary and nonmonetary costs to help you determine the real cost of borrowing.
The final cost of borrowing money often involves much more than just the interest rate. A variety of other monetary and nonmonetary costs should be considered in determining the real cost of borrowing.
For example, a loan that requires you to maintain certain financial ratios may be unrealistic for your particular business. Your checklist for reviewing the costs of a bank loan should include:
- direct financial costs, such as interest rates, points, penalties and required account balances
- indirect costs and loan conditions, such as periodic financial reporting, maintenance of certain financial covenants and subordination agreements
- personal guarantees needed to obtain the loan
Assessing the Direct Financial Costs
It goes without saying that the financial costs of a loan are important considerations in shopping for a lender or negotiating with a bank. But you may not be aware of everything that fulls under the umbrella of "direct financial costs."
As you crunch the numbers on the financial costs, keep these main loan features top of mind.
Negotiating a Fair Interest Rate Percentage
Any interest rate that exceeds the bank's prime rate should be considered negotiable. Now, that negotiable range is likely to be very small, but even an eighth of a point in interest can be a meaningful amount to your business. You should expect to pay a point or two over the bank's prime lending rate. Generally, the longer the term of the loan, the higher the interest rate.
Competition among banks makes shopping around for the best rates worthwhile. Occasionally, a local bank may decide that it needs to increase its small business lending by aggressively discounting its rates for a limited time period to new borrowers. Unfortunately, these banks often don't do a good job of advertising their programs and you might not discover an attractive rate unless you actively investigate.
Protecting Your Variable Interest Rate
Banks often prefer floating interest rates in making small commercial loans to minimize the already significant risks of lending to a small business.
As a borrower, you should try to negotiate a maximum interest rate cap on any variable rate. That way you have some idea of your maximum exposure on the loan.
Buying a Fixed Interest Rate
In some instances, you might also consider "buying" a fixed rate from the lender. Many banks will offer a fixed interest rate for a rate slightly higher than the current floating rate, e.g., an additional 1/2 percent. Both you and the bank are speculating whether the prime rate will rise or fall and how quickly the rate may move.
Minimizing Points or Fees
Upfront bank charges for a loan can be assessed for:
- reviewing and preparing documents
- performing credit checks
- simply agreeing to give you a loan
Points are one-time charges computed as a percentage of the total loan amount and the costs are amortized over the length of the loan. On lines of credit, some institutions may charge a commitment fee for keeping credit available to you. This fee typically runs approximately half a point or less on the unused portion of the credit line.
Try to challenge and reduce any and all points as fees. It never hurts to ask, and lenders will often budge slightly.
Negotiating Compensating Balances and Depositor Relationships
Some banks will require a short-term borrower to establish and maintain a specified balance in an account at the institution as a condition of the loan. For example, the bank may require you to keep at least 10 percent of the outstanding loan balance in an account.
This compensating balance (often in a low-interest-bearing account) is a way the bank makes a loan more profitable. In effect, the bank is reducing the principal amount of the loan and increasing the real rate of interest.
A compensating balance is negotiable and some banks simply request an informal "depositor relationship" with the borrower. This relationship requires only that the borrower use the bank for some other type of business, e.g., to maintain a credit card or open some type of traditional savings account. No set balances are usually required.
Avoiding Prepay Penalties
If a borrower prepays any of the principal on a loan, the bank does not get interest it expected to receive on that amount. To discourage such prepayments, some institutions will charge a fee for prepayment of certain loans (usually long-term).
It's always to your advantage to try to reduce—or completely eliminate—any prepay penalties. But if you have no luck, at least make sure you fully understand the prepay penalties.
In addition to these direct financial costs, you should consider the indirect costs attached to the particular loan you're considering.
Indirect Costs and Loan Conditions
Besides the direct financial costs of a business loan, you'll also want to consider these indirect costs and conditions:
Considering Time Involved for Periodic Reporting
Lenders will typically require periodic reports on the status of your
business. Reporting requirements on a small business loan can vary, but
local community banks will probably require only quarterly and annual
financial statements (your balance sheet and income statement) and annual personal financial statements
and income tax returns. However, if the loan is secured by accounts
receivable (or sometimes inventory), monthly reporting and aging
statements on these items will be required.
The good news is that not all banks require that the reporting
documents be prepared by a CPA. But even if they do, they may be
satisfied if the professional has simply prepared the final
compilations. Depending upon the bank's staff and the amount of lending
done, banks vary on the degree of scrutiny given to the reports.
Some smaller, local banks rarely confirm the accuracy of these
financial statements by any type of independent audit, and as long as a
quick review reveals no significant problems, the reporting requirements
are usually considered pro forma. As one banker noted, "In 15
years, I've only had five loans where the bank became significantly
concerned due to unfavorable financial reporting requirements, and all
of the situations were resolved after conference with the borrower."
A lender may require monthly statements for a loan secured by
accounts receivable because the accounts must frequently be "aged" to
assess their value, and because the loan-to-value amount is constantly
changing. For instance, assume your bank gave you a small working line
of credit for $30,000, secured by your accounts receivable. On
receivables that are under 60 days old, the bank has agreed to extend 75
percent of the value of those receivables. Monthly reporting on the
receivables is necessary so that the bank can ensure that the loan
remains secured by at least $40,000 of receivables that are under 60
How demanding your bank's reporting requirements are can consume a
small to a significant amount of your time. Even if you use a CPA to
prepare the reports, the time required to find and work with a CPA is a
Understanding Potential Financial Covenants
Conventional lenders typically include a variety of covenants and restrictions in the loan agreement. Some banks may:
- place restrictions on the use of loan funds
- require proper maintenance of business facilities (e.g., insurance coverage)
- require maintenance of key financial ratios such as debt-to-equity ratio, current ratio, and coverage of fixed charges ratio
- dictate minimum working capital balances, restrictions on the
amounts of dividend payments and salaries, mergers and acquisitions, and
limits on secondary or further pledges of assets
Some smaller community banks are less demanding because they don't
want to spend the time and money policing covenants. Often, the
covenants required by community lenders will limit the use of financial
ratios. Instead, these lenders may include only boilerplate provisions
governing maintenance of the collateral, requiring an informal depositor
relationship and a subordination agreement, and restrictions on using
the collateral as security for any other loans.
In reality, a wide range of covenants may not be a bad thing if your
business already falls in line with most of them. But if abiding by the
covenants requires major changes to the way you do business—and not
arguably for the better—consider this a major cost.
Working with Subordinate Agreements
This agreement stipulates that all corporate obligations such as
rights of shareholders, officers and directors are subordinated (made
lower in priority) to the bank loan. Default of these terms can mean
foreclosure on secured assets.
Nearly all small business commercial loans allow the bank to "call"
the loan due if the bank feels that repayment is seriously threatened.
If you're uneasy about the subordinate language, consult a legal or
financial professional to read over the loan paperwork—something, we
hope, you already were planning to do be signing on the dotted line.
Making Personal Guarantees to Obtain Financing
Here's the game that banks like to play during loan negotiations. The
banker will matter-of-factly states that a personal guarantee from all
the owners of the business, and their spouses, is mandated by their
routine lending policies.
You sit there, agree, and sign the papers dutifully. Or, you come armed with knowledge of personal guarantees.
Personal Guarantees Explained
A personal guarantee is a pledge, by someone other than the named
borrower, that he or she promises to pay any deficiencies on a specific
Most guarantee forms require joint and several liability, meaning
that each individual who signs a guarantee can be held responsible for
the whole amount of the loan. Consequently, even if someone is only a 10
percent owner in the business, that person is personally liable for 100
percent of the amount being guaranteed.
The bank can sue guarantors individually or collectively. There is no
requirement that, before the guarantor can be held responsible, the
lender must show that the borrower actually named in the loan document,
i.e., the business, is unable to pay the loan. In effect, when you sign a
personal guarantee, you become personally liable for the loan, even if
your business is incorporated.
How to Play Your Cards During Negotiation
Now, with some lenders, the name of this game is "take it or leave
it," and you'll have to sign a guarantee or forfeit the loan. However,
depending upon collateral and the creditworthiness of the business, room
for negotiation may exist, particularly when dealing with smaller,
community banks. Naturally, the banker is unlikely to tell you this. You
won't know until you test the bank's degree of dependence on this
Always try to emphasize, if applicable, that your business has
sufficient collateral to secure the loan and that a pledge of personal
assets is excessive security. As your business matures and establishes a
credit history, the lender's need for personal guarantees should
correspondingly decline and you should continue to negotiate the issue
of personal guarantees whenever the business seeks borrowed funds.
In addition, consider several other factors that may be negotiable in lieu of a personal guarantee, such as:
- a higher rate of interest or points
- borrowing a lesser amount or for a shorter period of time
- maintenance of a higher compensating balance for the loan
- limiting the terms of the guarantee itself (e.g., setting a
fixed monetary cap or a percentage of responsibility for the guarantee,
or excluding certain personal assets from the scope of the guarantee)
If the giving of a personal guarantee cannot be avoided—and for most
younger businesses, it won't be—try negotiating the terms of the
agreement. Offer a limited personal guarantee, for instance, of 25
percent of the loan. Or try to modify the capital or net worth minimums
that can automatically trigger the personal guarantee.
If your business takes on partners or additional owners over time,
try to get all new owners in the business to commit to a personal
guarantee on any pre-existing loans.
In a partnership, for instance, an incoming partner is usually not
personally liable for pre-existing business debts; absent the personal
guarantee, the new partner will not share the risk for those prior
commitments, although he or she may be enjoying benefits derived from
that loan. You want the liability to be spread as widely as possible so
that even if you are required to pay on the guarantee, you may be able
to seek proportionate contributions from other owners. (However, be
aware that there may be tax consequences to existing partners when their
liability for debts is reduced in this manner. Please consult your tax
advisor for more details.)
Finally, if your personal portfolio contains sufficient assets to
cover the loan, and your spouse independently owns other significant
assets, be prepared to present a case for why the spouse's personal
guarantee is unacceptable. A spouse cannot be legally compelled
to sign a personal guarantee; however, a hypothecation agreement is
commonly required. This agreement states that if the bank is required to
act upon the personal guarantee of the business owner, the spouse has
relinquished his/her rights in the jointly owned property held with the
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