Direct Financial Costs

The financial costs of a loan are important considerations in shopping for a lender or negotiating with a bank. Here are the main features to think about and compare:

Interest rate percentage. Any interest rate that exceeds the bank's prime rate should be considered negotiable. The negotiable range is likely to be very small, but even an eighth of a point in interest can be a meaningful amount to a small business. You should expect to pay a point or two over the bank's prime lending rate. Generally, the longer the term of the loan, the higher the interest rate.


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Competition among banks makes shopping around for the best rates worthwhile. Occasionally, a local bank may decide that it needs to increase its small business lending by aggressively discounting its rates for a limited time period to new borrowers. Unfortunately, these banks often don't do a good job of advertising their programs and you might not discover an attractive rate unless you actively investigate.

Variable interest rates. Banks often prefer floating interest rates in making small commercial loans to minimize the already significant risks of lending to a small business. As a borrower you should try to negotiate a maximum interest rate cap on any variable rate, so that you have some idea of your maximum exposure on the loan.

Fixed interest rates. In some instances, you might also consider "buying" a fixed rate from the lender. Many banks will give you a fixed interest rate for a rate slightly higher than the current floating rate, e.g., an additional 1/2 percent. Both you and the bank are speculating whether the prime rate will rise or fall and how quickly the rate may move.

Points or fees. Upfront bank charges for a loan can be assessed for reviewing and preparing documents, performing credit checks, and for simply agreeing to give you a loan. Points are one-time charges computed as a percentage of the total loan amount and the costs are amortized over the length of the loan. On lines of credit, some institutions may charge a commitment fee for keeping credit available to you. This fee typically runs approximately half a point or less on the unused portion of the credit line.

Compensating balances and depositor relationships. Some banks will require a short-term borrower to establish and maintain a specified balance in an account at the institution as a condition of the loan. For example, the bank may require you to keep at least 10 percent of the outstanding loan balance in an account. This "compensating balance" (often in a low-interest-bearing account) is a way the bank makes a loan more profitable. In effect, the bank is reducing the principal amount of the loan and increasing the real rate of interest.

A compensating balance is negotiable and some banks simply request an informal "depositor relationship" with the borrower. This relationship requires only that the borrower use the bank for some other type of business, e.g., to maintain a credit card or open some type of traditional savings account. No set balances are usually required.

Prepayment penalties. If a borrower prepays any of the principal on a loan, the bank does not get interest it expected to receive on that amount. Some institutions will charge a fee for prepayment of certain loans (usually long-term) to discourage such prepayments.

In addition to these direct financial costs, you should consider the indirect costs attached to the particular loan you're considering.