Why pricing is confusing
Business financing does not follow a single pricing standard. A bank might quote an interest rate tied to the prime rate. An online lender might quote a simple interest rate or a monthly rate. A merchant cash advance or short-term working capital provider might quote a factor rate. On top of that, fees can be charged up front, deducted from the funds, or added over time.
Because each format measures cost differently, comparing quoted numbers directly can be misleading. A lower-looking number is not always the cheaper option. Understanding how each method works is the first step to comparing them fairly.
Interest rates
Most traditional loans charge interest on the outstanding balance. As you repay principal, the balance shrinks and so does the interest portion of each payment. This is how amortizing loans, such as SBA and bank term loans, typically work.
Rates can be fixed, staying the same for the life of the loan, or variable, adjusting periodically based on an index such as the prime rate plus a margin. With a variable rate, your payment can rise or fall over time. The prime rate changes with broader interest rate conditions, so check the current figure when you evaluate a variable-rate offer.
Some lenders use simple interest calculated on the original amount rather than the declining balance, or quote a monthly rate. Ask how interest is calculated, because the method can change the total cost significantly.
APR
Annual percentage rate, or APR, expresses the cost of financing as a yearly rate that includes interest and certain fees. Because it accounts for fees and timing, APR is generally more useful for comparison than an interest rate alone.
APR is especially revealing for short-term products. A fee or charge that looks modest on a six-month loan can translate into a high APR because you are paying it over a short period. A growing number of states now require providers of certain commercial financing to disclose an estimated APR and total cost, which makes comparing offers easier where those rules apply.
APR has limitations. For products with uncertain timing, such as a merchant cash advance repaid as a percentage of sales, the APR is an estimate based on assumptions about how quickly you repay. Use it as a guide, not a precise figure.
Factor rates
A factor rate is a multiplier, usually written as a decimal such as 1.2 or 1.35, applied to the amount financed to determine the total repayment. For example, borrowing $50,000 at a factor rate of 1.3 means repaying $65,000. The $15,000 difference is the financing charge.
Factor rates are common with merchant cash advances and some short-term working capital products. The key difference from interest is that the charge is fixed up front. It does not shrink as you pay down the balance, and in many cases paying early does not reduce the cost unless the agreement includes an early payoff discount.
A factor rate of 1.3 is not the same as a 30% interest rate. If the term is short, the annualized cost can be much higher than 30%. Always convert factor-rate offers into total dollar cost and, where possible, an estimated APR before comparing them with interest-based loans.
Fees that affect your cost
Common fees include origination fees, which are charged for processing the loan and often deducted from the proceeds; underwriting or application fees; closing costs on real estate loans; SBA guarantee fees on SBA loans; and packaging or broker fees. Lines of credit may have draw fees, maintenance fees or annual fees.
Pay close attention to fees deducted from the funds. If you are approved for $100,000 but a fee is withheld, you receive less than $100,000 while still repaying based on the full amount. That raises your effective cost.
Also review prepayment terms. Some loans charge a penalty for paying off early, while some factor-rate products offer no savings for early payoff. Late fees, returned payment fees and default provisions matter as well, even if you do not plan to use them.
Payment frequency and term
The length of the term and how often you pay affect both cost and cash flow. Longer terms usually mean lower payments but more total interest. Shorter terms reduce total interest but increase the payment.
Daily or weekly payments, common with some alternative products, start reducing your cash immediately and can strain cash flow during slow periods. Compare offers on a monthly equivalent basis to see the real impact on your budget.
How to compare total cost
For each offer, write down the amount you will actually receive after fees, the total amount you will repay, the payment amount and frequency, the term, and the APR or estimated annualized cost. Then subtract the amount received from the total repayment to see the true dollar cost of the financing.
Compare the dollar cost and the annualized cost together. A longer loan may cost more total dollars but have a lower APR and a more manageable payment. A shorter product may cost fewer dollars overall but carry a much higher annualized rate and heavier payments.
Finally, weigh the non-price terms: collateral, personal guarantees, prepayment rules and covenants. A WellRounded Capital advisor can help you put offers on the same footing so you can see which one actually costs less for your situation.