For Retailers, What is the Real Cost of Borrowing?

Retailers need financing for numerous things. Although more funds are available for business lending, often unanswered is all-important question of what is actually the cost of borrowing?

For Retailers, What is the Real Cost of Borrowing?

It would be an understatement to say small business lending, especially the firearms industry, has taken a significant blow over the past few years. Political pressure combined with lower interest rates have translated into lenders being more selective. Fortunately, with many larger businesses reducing their borrowing needs, there is increased attention on small business lending.

Tactical retailers need financing for technology software and websites and inventory loans as well as funding for advertising, marketing and social media. Although more funds are available for business lending, often unanswered is all-important question of what is actually the cost of borrowing? 

The Cost of Borrowing

All too often, the interest rate stated by lenders does not reflect the true cost of a business loan. Put another way, the borrower may not be getting the full amount of the loan. The loan agreement may require that the borrowing 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: With a discounted loan, the interest is subtracted from the total amount of the loan. Usually short-term, the proceeds received by a borrower, and available for use, represent the difference between the face amount of the loan and the stated interest.

For example, assume the stated interest rate on the loan is 12%, the face amount of the loan is $100,000 and the term is one year. The total interest (12% of $100,000 for one year) is $12,000. Since 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%

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 firearms retailer, pays interest on the entire loan. 

Assume a $100,000 loan, term of one year, interest rate of 12%. The compensating balance requirement is 15% 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% of $100,000). The effective interest rate is computed: 

Interest/Net proceeds = Effective interest rate 

$12,000/$85,000 = 14.12%

DOUBLING UP: Surprisingly, a shooting sports equipment retailer could have a loan that is subject to both requirements, that is, the loan could be both discounted and compensating balances required.

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

For example, a borrower 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% interest on the total. If only $70,000 is borrowed the interest will be $8,400 (12% of $70,000). However, the borrower will have to pay a 1% 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%

INSULT TO INJURY: 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. 

More Fees to Think About

Let’s face it, lenders are businesspeople 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 some or even many 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., which generally 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 tactical retailer 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 they need to analyze the probability that the loan will repay in a timely manner. In other words, the processing fee compensates the lender for the time, work and expertise required to complete this stage.  

* Underwriting fees: Once a loan application package is complete, it normally goes to the lender’s underwriting department where either a person or a committee studies it, verifies that all the information provided is true, assesses the risk the lender would be taking and, hopefully approves or denies the 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 fees are absorbed by the lender or the seller of the property in order to encourage the sale.

* Maintenance or servicing fees: These are fees that 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.

And there is a fee unique to U.S. Small Business Administration programs:

* SBA Guaranty Fee: When an SBA loan is granted, the tactical retailer/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, every tactical retailer should remember that 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 cost, often called a “lost opportunity” cost, is the amount those same funds would have earned had they remained in savings or invested. Today’s low interest rates that savings earn might substantially reduce that lost opportunity cost, but it remains a factor to be considered.

Another, frequently overlooked cost to not borrowing is that a shooting sports equipment business 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.

Alternative Funding

While obtaining bank loans is rarely easy, when the tactical retailer does obtain it they may not be getting the best rates and terms available. Although usually more easily obtained, and more expensive, alternative business loans are the perfect option for firearms dealers and other small businesses that have been declined for more conventional, traditional business loans.

There are many different types of alternative business loans — each with their own requirements and lending criteria. So-called “asset-based” lending is one form of alternative financing.

Commercial finance companies are often willing to lend funds to businesses that cannot, for various reasons, secure credit from a bank. The credit is secured by the assets of the business, such as receivables, inventory, equipment and sometimes real estate. However, while asset-based lenders usually advance capital more quickly and more readily than banks, they charge more for the higher risks involved.

An emerging segment of the financial services industry uses online “platforms,” such as Crowdfunding, Peer-to-Peer Lending and Marketplace Lending to lend directly or indirectly to consumers and small businesses. But, once again, requirements, terms, fees and costs vary among on-line portals. 

Now might be a good time for every shooting sports equipment retailer to perform a cost/benefit analysis. A Cost Benefit Analysis is a decision-making tool often used in making financial decisions by weighing costs against the benefits of the decision.

The increasing number of financing options available is making funding more readily available. Plus, with many financing options out there both shopping for a lender and negotiating terms are possible. 


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