Knowing when to take a business loan is easy. If the loan rate is “low,” then you take the loan. If the loan rate is “high,” then you decline the loan. Easy, right? NO.
As the CEO of Camino Financial, we’ve funded millions in small business loans to businesses with annualized interest rates from 12% to 29%. Every once in a while I encounter business owners who gasp at the idea of paying an interest rate above 20%. My response is simple:
Only take a loan when you can make a positive return on the investment.
It’s common to hear stories of entrepreneurs like Steve Jobs, who took loans at much higher interest rates than 20% and made billions. These entrepreneurs knew how to use other people’s money to make money, like 200%+ returns on investments. When looking at pricing from this perspective, a 20% cost of capital seems really small for such a large return, right?
Don’t get me wrong, I understand it sounds crazy for business owners to make a 200% return by investing in their business. In fact, I do not endorse business owners taking on loans from Camino Financial without proper evaluation of the use of proceeds and potential return on investment. Nor do I believe borrowing at interest rates above 20% is sustainable over the long-term for any business, even Apple (with debt priced at 3.6%).
“An interest rate is fair, if the cost of the loan generates a positive return on investment.” -Sean Salas
In this article, we’ll give you 5 tips to help you as a small business owner determine the fairness of loan pricing.
How do I know if a business loan rate is fair?
Simply follow these tips:
1. Calculate Return on Investment for the Loan
Let’s quickly review the formula for Return on Investment, also known as ROI: Profit of Investment ÷ Total Cost of Investment.
Let me use a simple example to make sure we understand the formula: Let’s say Sofia purchases stock in company AYZ for $1,000 and then sells the stock for $1,200. In this case, Sofia would generate a profit of $200 ($1,200 – $1,000 = $200). Dividing the profit by $1,000 cost of the investment would result in ROI of 20%.
Makes sense? Ok, now it’s time to apply this formula to a loan. For this, I will use the Camino Financial Business Loan Calculator.
Let’s say you are a supplier of tortillas. You currently have so much demand that you need to buy another tortilla mixer that costs $10,000. The good news is once you buy the new tortilla mixer you should be able to make another $5,000 per year from selling extra tortillas. Since you don’t have $10,000 in your bank account, you decide to borrow from Camino Financial who offers you a 3-year loan at a 24% interest rate. To make sure this loan delivers a positive return on investment, you do the quick ROI math:
- Go to the Camino Financial business loan calculator and see a 3-year business loan at a 24% annualized interest rate has a total cost of $4,822.83, including origination fees
- Then, calculate the cash gain from buying a tortilla mixer over the 3-year term of the loan: $15,000 ($5,000 x 3 years)
- Next, calculate the profit over the term of the loan: $15,000 (total cash gain) – $4,822.83 (total cost of investment) = $10,177.17
- Now calculate the simple ROI formula: $10,177 (profit)÷ $4,822.83 (total cost of investment) = 211%
In this scenario, borrowing $10,000 at a 24% annualized interest rate delivered to the business owner a 211% return on investment. Do you think this is a fair or EXCELLENT investment?
2. Know You Gotta Start Somewhere
Small business owners who cannot get a loan from a bank are likely to have limited to no business credit history.
Here’s a fun fact about lenders: most 5-9% interest rate lenders do not want to be the first to lend capital to your business. The reason is your business does not have a credit track record that demonstrates its ability to pay back the loan.
Another reason may be you do have a credit history either personal or business, but you have a history of delinquent repayments. This means you need to rebuild your credit history.
Whether you are building or rebuilding your credit, everyone needs to (re)start somewhere. The starting point differs based on many different variables:
- Is there collateral to guarantee the loan?
- Is the government offering subsidized financing via SBA loan programs?
- How quickly do you need the capital?
- How long have you been operating your business?
- How much cash profit is your business currently generating?
- What’s your personal credit score?
- Do you have all the financial and legal documentation required to apply for a loan?
- What are you going to use the capital for?
- What is the nature of your business?
Depending on the answers to these credit-related questions, the starting point of the interest rate can be 6% or 40%+ based on the lender and type of loan. One thing is for sure, you need to start somewhere. As you build a relationship with your lender with timely repayments and grow your business, there is only one way the interest rate will go: down.
3. Understand the Collateral of the Loan
Collateral has the biggest impact on the interest rate of the loan. Think about it from a lender’s perspective.
In Scenario A, an equipment finance company lends to Miguel $10,000 to purchase a new refrigerator. As collateral, the borrower offers a vehicle valued at $5,000. In addition, the lender places a lien against the refrigerator in case of a default. A year later Miguel goes out of business and no longer has the cash to pay down his loan with a pending balance of $7,000. At this point, the finance company collects the collateral of $5,000 of the vehicle, as well as the refrigerator that has a residual value of $5,000. In the case of default, the finance company principal losses are 140% recovered from the value of the collateral. In addition, the interest earned helps cover the cost of the collection services + a profit margin. Even in the scenario of a default, the loan may be profitable to the finance company. For this reason, you should see collateralized loans priced in the single digits.
In Scenario B, Camino Financial lends to Miguel $10,000 to purchase a refrigerator. Camino Financial does not require collateral but requests a lien on the refrigerator and a personal guarantee. Like in Scenario A, Miguel can no longer pay back the loan after a year with a pending balance of $7,000. Then, Camino Financial collects the refrigerator with a residual value of $5,000, resulting in a total principal loss of $2,000 + expenses related to servicing and collections of the loan. To make uncollateralized loans profitable to any lender, the interest charged to the borrower needs to be enough to cover potential losses in principal + collections fees + profit.
For this reason, uncollateralized loans tend to be priced at higher interest rates, lower loan amounts, and shorter terms for repayments. As the borrower builds a relationship and repayment history with the lender, the borrower will have the opportunity to refinance the loan with more capital at lower interest rates.
Learn more about what collateral means in our post on unsecured business loans.
4. Pay Attention to the Details
Many lenders represent the terms of the loans in different ways for different reasons. Here are important loan terms to be mindful of:
- Interest Rate: Be sure to understand if the interest rate is annualized vs. monthly. Short-term lenders, like Camino Financial, prefer to disclose interest rates on a monthly (vs. annual) basis.
- Factor Rate: Many short-term business lenders quote pricing on a factor rate. If a factor rate is 1.25, this means for every $1 borrowed you need to pay back $1.25. In this scenario, the cost of funding is $0.25. Many business owners get in trouble when they assume the 1.25-factor rate is equivalent to a 25% interest rate. False!!! In fact, if someone is quoting a factor rate on a loan with terms below 24 months, then the implied interest rate can be significantly higher than you’d expect. For instance, the factor rate of 1.25 on a 12-month term loan is equivalent to an annualized interest rate of 43.5%!!!
- Fees: Small business loans have closing fees in the range of 4% and 7%. Other fees include late payment fees and SBA guarantee fees. Be sure to calculate all the applicable fees when running your ROI calculation. At Camino Financial, our business loan calculator includes the full cost of the loan, including expected closing fees. We have no Documentation or Funding fee.
- Annual Percentage Rate (APR): APRs is equivalent to the annualized interest rate + annualized fees charged by the finance company. APRs can be helpful when comparing the cost of multiple loan options.
- Payment Frequency: Pay attention to the repayment schedule of loans. Daily or weekly repayment frequencies may defeat the purpose of the loan since it creates stress for repayment, especially when funds are used for working capital purposes.
- Payment Terms: When running your ROI calculation, take into account the amount of time it will take to get a full return on investment. Back to the example where you purchase a tortilla mixer at a 211% ROI: imagine if the term of the loan were only 12 months instead of 3 years. Let’s also assume the ramp-up in cash generation from the new tortilla mixer takes 2 years so you don’t see new profits in the first year. In this case, the short-term ROI is actually negative given the disconnection between the short term of repayment of the loan and the longer ramp-up period of the investment.
- Prepayment Penalties: Prepaying loans with no fees is great, especially when your investment ramps up faster than expected. In this scenario, you can pay off the loan and save on interest expenses, thus increasing your overall ROI. Unfortunately, lenders are not fans of prepayments since they make less money for taking on capital risk. For this reason, many lenders charge a prepayment penalty. We don’t charge any prepayment penalties at CF. IMPORTANT: Beware of lenders who quote on a factor rate and mention “no prepayment penalties.” This statement is very misleading since the full balance of the factor rate needs to be paid in full regardless of the timing of repayment. The lender’s rationale: technically they aren’t charging you extra for paying before the scheduled repayment. Funny, not funny . . .
5. Understand the Cost of Not Taking the Loan
Probably you have considered the perks of getting a business loan, but It’s also important to calculate the cost of not taking the loan, also referred to as the opportunity cost.
Let’s use the following example to evaluate opportunity cost: you are a retailer of high-end luxury jewelry and you find a “once in a lifetime” opportunity to purchase a limited supply of high-priced jewelry valued at $1 million at a 90% discount. The only catch is you need to purchase the inventory for $100,000 in 5 days, otherwise, the deal is off. This is an extreme scenario where the cost of not purchasing this inventory could result in $900,000 in forgone cash gains. So technically, you are ROI positive as long as the cost of borrowing $100,000 does not exceed $900,000.
Let’s see another example that revolves around timing. Taking loans accelerates the speed at which a business grows. Otherwise, a business owner needs to wait until its generating enough capital to make the same investment. With certain businesses timing makes or breaks you, but accelerated growth does come at a risk. If the business defaults on a loan, then the owner puts her/his credit score, collateral, and personal assets at risk. So it’s important to evaluate if the timing is really worth the risk. To assess this opportunity cost, make sure you ask yourself the following question:
- What type of risk am I taking on personal assets and collateral? Are these assets worth losing in order to grow faster?
- How often do high ROI opportunities present themselves to my business?
- How fast are my competitors growing? What happens if I don’t grow as fast as them?
- Can I pay off the loan even if I do not grow as fast as expected?
I hope these tips help evaluate the fairness of pricing and terms of a small business loan. Keep reading here if you still unsure that a business loan is the right fit for you.