Direct Financial Costs
- Interest rate percentage. Every interest rate that is above the bank's prime rate should be considered negotiable. Even though the negotiable range is very small, an eighth of a point in interest can result in a significant amount of savings. In general, a small business should anticipate paying one or two points above the bank's prime lending rate. Usually, the longer the loan, the higher the interest rate.
The recent increase in competition between banks makes shopping for the lowest rates sensible. Occasionally, a bank will choose to increase its small business lending. They do this by discounting its rates to new borrowers for a limited time period. When this happens these banks don’t often do a very good job of advertising, so you might not find out about a discounted rate unless you search around.
- Variable interest rates. Banks prefer floating interest rates
when making small loans. This minimizes the significant risks of lending
to a small business. A borrower should try and negotiate a maximum
interest rate cap on any variable rate. This will give you an idea of
the upper limit of risk exposure on the loan.
- Fixed interest rates. You should also consider "buying" a
fixed rate loan from the lender. Many banks will give you a fixed
interest rate for a rate slightly higher than the current floating rate.
The interest rate is typically about an additional 1/2 percent. This is
risky, because both you and the bank are speculating whether the prime
rate will rise or fall. In this instance the bank is usually better
informed and can make an educated guess.
- Points or fees. Banks usually charges upfront fees for a
loan. They are assessed for reviewing and preparing documents,
performing credit checks, and for simply agreeing to give you a loan.
The “points” are one-time charges computed as a percentage of the total
loan amount. The costs are amortized over the length of the loan. Some
institutions even charge a fee for keeping your line of credit open.
This fee is usually bout half a point on the idle portion of the credit
line.
- Compensating balances and depositor relationships. Some banks will require borrower to keep a specific balance in an account as a condition of the loan. This is a way for the bank to makes a loan more profitable for them because they generally only pay a low interest rate on the balance. In effect, the bank is reducing the principal amount of the loan and increasing the real rate of interest.
A compensating balance is negotiable. Some banks only request an informal "depositor relationship" with the borrower. The terms of this relationship require that the borrower use the bank for some other type of business. Maintaining a credit card or a traditional savings account typically satisfies this. This relationship usually requires no set balance.
- Prepayment penalties. Beware of prepayment penalties. If a borrower prepays any principal on a loan, the bank does not get the full amount of interest it expected to receive. To discourage this, some institutions will charge a prepayment fee.
Return to The True Cost of Borrowing Money
© 2001 Missouri Innovation Center