The True Cost Of Debt

Most small and emerging businesses use debt as part of their financing structure. (The exceptions--and they have dwindled--are those high-potential ventures that can raise money through promises of potentially lucrative slices of equity.) The question: How much does that money cost?

The financial crisis is proof that too few people either 1) know how to perform these calculations or 2) bother to live by what the numbers are telling them. The first part is somewhat easily remedied; the second, sadly, is perhaps something only a painful recession can drive home. 

If you borrow $100 for one year at a 10% annual rate, you owe $110 a year from now. This is the simplest way to calculate interest--but if you hadn't already guessed, hardly anything in life is so simple, especially when it comes to alternative financing schemes. 

Consider the following:

Monthly payments of interest only. As I am sure you have noticed, lenders like to receive interest each month. (Bonds carry less frequent payments, with quarterly or semi-annual installments, but smaller businesses usually do not have access to the bond market.) Here's where things get tricky: Paying interest monthly effectively raises your interest rate.

Say the lender says it will lend to you at 12% per year, to be paid 1% per month. (On $100, that means you will pay $1 each month.) But by paying monthly, you have raised your effective rate, which takes into account the time value of money. Observed through that lens, your annual interest cost is 12.7%. The formula for effective rate can be duplicated quite easily on many financial calculators, or even a simple Excel spreadsheet.

Amortizing loans. Car and house loans often require an equal monthly payment that includes principal and interest. On these, the difference between the nominal rate and the effective rate can be significant. 

Example: Say you borrow $100 for one year with equal monthly payments of principal and interest, and the lender says the annual rate is 12%. The normal practice is to calculate the monthly payment based on an amortization schedule, using a 1% rate per month. In that case, the effective annual rate is 12.7%. 

Beware! Some unscrupulous lenders might calculate your monthly payment to be $112/12, or $9.33 per month. (Their nefarious logic: The interest payments are based on the initial principal, not the outstanding principal, which clearly diminishes over time.) Here, the effective rate is nearly double the nominal rate, or a whopping 23.5%. 

Prepayment of interest. Some lenders will deduct the interest from the loan amount and lend the net figure, while still expecting repayment of the entire face value of the loan. Again, the stated interest rate undershoots reality. Say you borrowed $100 at a stated 10% rate for one year, but the bank only hands over $90. Your effective annual interest is $10 / $90, or 11.1%.

Compensating balances. This maneuver isn't used much anymore, but some lenders used to demand that borrowers keep a certain percentage of the loan in the bank, meaning that they would lend you the stated amount on their books but only hand over a portion. So, on that $100 loan, if the compensating balance is 20%, or $20, and the interest is $10 (or 10% of $100), then the effective loan amount is $80--boosting the effective rate to 12.5%.

A word about fees and penalties: Some lenders charge an upfront fee; others do not. If you are paying a fee of 2% of the principal amount, it is similar to borrowing $100 and having to repay $102 plus interest. You better believe those little fees can have a substantial impact over the long haul. Say you borrow $100,000 over 20 years at a stated rate of 7% and the upfront fee is 2%. Without the fee, that monthly payment is $775--with the fee, it is $790. Effective annual rate: 7.48%.

Note: Some lenders may charge low interest rates and fees but enforce strict terms. Fail to meet the terms of the loan, and you'll get whacked with a penalty.

Term loan versus line of credit. Really understand your needs before you strike a deal. If your business is seasonal, you may be in the market for a potentially cheaper line of credit, rather than a regular term loan.

Example: Suppose you only need $100 for six months. You could take out a one-year term loan at a stated 10% rate that also comes with stiff pre-payment penalty (that is, you pay back $100 in principal and $10 interest at year's end). Or, you could open a one-year "committed" line of credit (also called a revolver) at a 12% annual rate, on which you have to pay an annualized fee of 2% on any amount you didn't draw down during the year. Which to choose?

In the term-loan scenario, say you use the $100 for the first six months. Because you don't want to suffer a penalty for prepaying it before the full year is up, on the first day of the seventh month you put that $100 in a money-market fund yielding 4% per year, translating to $2 in earnings for the remainder of the year. Net financing cost: $10 - $2 = $8. (Note that some of the terms in this example may not seem realistic because you may just borrow the funds for six months--my point with a one-year, non-amortizing loan is to make a simple apples-to-apples comparison.)

Now look at a line of credit. Suppose you tapped that $100 line for the first six months, at the 12% annual rate, but repaid the principal and interest and didn't touch it for the last six months. That means that after six months you paid back the $100 along with $6 in interest. Now tack on that 2% fee for the unused funds--or 1% for six months. In that case, you paid $6 in interest in the first six months plus $1 for the commitment fee, for a total of $7.

What it all means: In this stylized example, you are more likely to benefit from the line of credit if the interest rate on the line is below 14%. That's because, at 14%, you will pay $7 in interest for the first six months, plus $1 for the unused amount during the remaining six months. So that 12% credit line a few paragraphs back is looking pretty good.

The math may be initially confusing, but the lesson here is simple. When it comes to borrowing money, do your own calculations and be sure to shop around. Even if you have to apply for a government-guaranteed loan, know that your lender can often sell off the guaranteed portion in the secondary market and earn handsome fees. 

Don’t let lenders make you think they are doing you a favor if you are a sound credit. And if you aren't so sound, take steps to improve. For tips, check out Finance Any Business Intelligently, available at www.infinancing.com.

Article by Dileep Rao 01.26.09, 6:01 PM ET (originally published here at forbes.com)

Dileep Rao is the president of InterFinance Corporation, which consults with governments, lenders and businesses on venture growth. Rao is also an adjunct professor of entrepreneurship and venture finance at the Carlson School of Management. He holds a Ph.D. in business administration from the University of Minnesota. Dileep can be reached at drao@infinancing.com.