The real cost of borrowing

It would be an understatement to say small business lending has taken a significant blow over the past few years. The freeze on small-business lending may be starting to thaw. Small-business lending is rising, according to several surveys. Recently the Federal Reserve announced plans to pump up to $40 billion a month into the economy.

While the Fed plans to purchase mortgage-backed securities, the strategy may make more money available for lending to growers, garden centers and nursery retailers. Unfortunately, with interest rates so low the only way many lenders can profit from small businesses lending involve “fees.” Which brings up the all-important question: how much does that borrowed money cost?

Adding it up
Often the interest rate stated by lenders does not reflect the true cost of a business loan. The loan agreement may specify that the borrowing nursery or growing business maintain compensating balances, pay a commitment fee or the loan may be discounted. And these are only the more frequently encountered terms.

Discounted loans. When a loan is discounted the interest is subtracted from the total amount of the loan. Thus, the proceeds received by a borrower, and available for use, represent the difference between the face amount of the loan and the stated interest. Discounted loans are usually short-term.

For example, assume the stated interest rate on the loan is 12 percent, the face amount of the loan is $100,000 and the term is one year. The total interest (12 percent of $100,000 for one year) is $12,000. Because the interest is paid up front, subtracting this from the face amount yields $88,000 of funds available for use. The effective interest rate is computed:

Interest/Net proceeds = Effective interest rate
$12,000/$88,000 = 13.64 percent

Naturally, if the maturity of the loan is less than a full year, an adjustment must be made for the shorter term.

Compensating balances. Compensating balances are similar to discounted loans because the bank requires the borrower to leave a portion of the loan in the bank, effectively reducing the amount of funds available for use. Of course, the borrower, the nursery business, pays interest on the entire loan.

Assume a $100,000 loan, term of one year, interest rate of 12 percent. The compensating balance requirement is 15 percent of the loan. Thus, while $100,000 is borrowed, and interest paid on $100,000, the amount available for use is actually only $85,000 ($100,000 less 15 percent of $100,000). The effective interest rate is computed:

Interest/Net proceeds = Effective interest rate
$12,000/$85,000 = 14.12 percent

Doubling up. Surprisingly, a grower could have a loan that is subject to both requirements. The loan could be both discounted and compensating balances required. Using the numbers in the two examples above, the funds available would be reduced by the $12,000 interest paid up front, and the $15,000 compensating balance. The formula is the same, but the net proceeds are only $73,000 ($100,000 less $12,000 up-front interest payment less $15,000 compensating balance). Dividing the $12,000 interest by the $73,000 in proceeds results in an effective interest rate of 16.44 percent.

Commitment fee. In some cases a so-called “commitment” fee is charged by a lender. This fee is to compensate the bank or other lender for having the money available to lend. Typically the fee may be 1 percent of the amount not taken down or borrowed.

For example, a borrower may may need as much as $100,000 during the coming year. Currently, however, only $70,000 is needed. If the business borrows the full $100,000 it will pay 12 percent interest on the total. If only $70,000 is borrowed the interest will be $8,400 (12 percent of $70,000). However, the borrower will have to pay a 1 percent commitment fee on the $30,000 not taken down. In effect that’s a $300 annual charge for the right to borrow an additional $30,000 should it eventually be needed.

To compute the true interest rate on the amount borrowed ($70,000) the commitment fee must be added to the interest charge and the fee subtracted from the loan proceeds (since the fee is paid up front). Thus, the effective interest rate is computed:

(Interest cost + Commitment fee)/(Amount drawn down - Commitment fee) = Effective interest rate

($8,400 + $300)/($70,000 - $300) = 12.48 percent

The commitment fee can be assessed in combination with either a discounted loan and/or a compensating balance requirement. When calculating the combined effect of these terms remember to reduce the amount of the loan proceeds available for use and increase the interest cost by the amount of any special charges.

Wait, there’s more
Like you, lenders are in the business of making money. They provide a service — a valuable one at that — and charge for it. How reasonable those charges are will always be debatable.

While there may be other fees and charges associated with a loan, among the most common are:

• Packaging fee: When you apply for a loan, you are required to provide a lot of information about yourself, your business, your finances, etc. This needs to be backed by appropriate documentation. If you receive assistance from a third party or the lender itself in completing the loan application, the nursery business may be charged by the third party or the lender.
   
• Processing/Application fee: As part of underwriting, there is a credit check of both the owners and the business and maybe even a personal background check. All this information is gathered and processed by lenders in order to make sure that the application package has the information necessary to analyze the probability that the loan will repay in a timely manner.
   
• Underwriting fees: Once a loan application package is complete, it goes to the lender’s underwriting department, where a person or a committee studies it, verifies that the information provided is true, assesses the risk the lender would be taking and, hopefully, approves or denies your application.
   
• Closing costs: Closing costs are usually associated with mortgage loans and can include — but are not limited to — expenses such as attorney fees, title search, realtor fees, etc. If a business loan includes a real estate transaction, the lender will certainly incur closing costs. Sometimes these are absorbed by the lender or the seller of the property to encourage the sale.
   
• Maintenance or servicing fees: These are fees the lender may charge on an ongoing basis (monthly, quarterly) to service a loan, i.e., handling payments, sending out notices, responding to inquiries, etc. There is also a fee unique to U.S. Small Business Administration programs:
   
• SBA Guaranty Fee: When an SBA loan is granted, the nursery or growing business borrower usually reimburses the fee the lender is required to pay to the SBA. Think of this fee as “points.” The fee is based on a percentage of the amount of the guaranty that SBA is providing. Fortunately, the fee can be financed, allowing the borrower to add it to the principal amount to be repaid, substantially reducing its impact.

Lost opportunity cost
Before shying away from the high cost of financing, remember there are also costs associated with not borrowing. Consider the owner who lends his or her own funds to the business.

In this case, the “lost opportunity” cost is the amount those same funds would have earned had they remained in savings or invested. Today’s low interest rates might substantially reduce that lost opportunity cost, but it remains a factor to be considered.

Another frequently overlooked cost to not borrowing is that the nursery operation may stagnate, be forced to pass up growth opportunities, and even be left in the dust by expanding, modernizing competitors, or those better able to finance increased efficiency.

Come and get it
Whether already available or more readily available thanks to the Federal Reserve’s pumping more funds into the marketplace, business loans can and will vary by lender and amount. Shopping around to both find a willing — and an affordable — lender involves looking at more than the interest rate.

Many nurseries have taken a “wait and see” approach when it comes to decisions about expansion, acquisitions, and financing. With higher interest rates and inflation on the horizon, they should consider the cost of borrowing or inaction.

Mark Battersby is a freelance writer in Ardmore, Pa. His tax and financial features have appeared in leading business magazines and trade journals for more than 25 years.