How to Compute the True Cost of a Loan

You've received loan offers from three different banks. Here are the term sheets:

	Bank A	Bank B	Bank C
Loan Amount	$400,000	$400,000	$350,000
Interest Rate	7%	8%	6%
Term/Amortization	36 months	36 months	48 months
Closing Costs	$250	$1,350	$5,000
Discount Points	0	1	2
Compensating Balance	$25,000	$0	$0

Which is the better deal?

If you can answer this, you're a financial savant of the highest order. But if you're not sure how to objectively determine which offer makes the most financial sense, I hope you will take a few minutes and let me equip you with the know-how you need. It's a skill you'll use often as a business owner. Even so, many of your peers will spend their careers making decisions like these without the benefit of sound financial analysis and the clarity of objective results.

To be sure, there are several ways to objectively analyze loan offers. But the one we recommend is Internal Rate of Return (IRR). We'll describe this method herein. In fact, here are the three main things we'll cover:

• Concepts Needed to Evaluate Loan Offers
• Definitions of Relevant Terms
• How to Crunch the Numbers

Concepts Needed to Evaluate Loan Offers

As with any decision, it is important to first develop a conceptual framework for addressing the problem. Here are concepts that are relevant in assessing loan offers:

Time Value of Money: Money has value. It can be used to purchase goods and service or invested to earn additional money. So when we borrow, the person or firm that lends the money will be unable to put it to use in other ways. So to entice the lender to lend it to us, we must be willing to compensate the lender with an amount that at least matches the value it could receive by putting the money to use in other ways. It is a rental rate, if you will, for temporary use of the funds (i.e., interest rate). Similarly, time value of money means that a dollar is worth more today than tomorrow. This is the point of discounting, where we use discount rates to value (i.e., discount) dollars to be received in the future in today's dollars.

Risk: Lenders lend money to make a return (i.e., profit). This means they need to end up with - at the end of each month, quarter or year - more money than they started with. If a borrower fails to remit all the principal and interest due to the lender under the terms of a loan, the lender will have a hard time achieving this goal. To minimize and mitigate the risk they bear in nonpayment, lenders will do three things:

• Diversify by lending to many different borrowers and borrower types in an effort to minimize the exposure to any single borrower or borrower type.
• Charge rates that reflect the levels of risk.
• Structure loans (collateral, covenants, amortization, guarantees, reporting requirements, etc.) to minimize risk of loss, especially for loans that have higher risk characteristics.

Borrowers, industries, geographic locations and types of companies possess different risk characteristics. Lenders will naturally charge higher rates and tighten loan covenants for loans that have higher risk characteristics (i.e., higher rates of default). They also may decide to limit (or not extend credit at all) the amount of credit extended to certain types of borrowers, industries, geographies and company types - to the extent that it is legal. So if your company has high risk characteristics - such as earnings volatility, elevated levels of debt, high industry cyclicality, customer or vendor concentration, poor internal controls, etc. - you can expect higher borrowing costs.

Inflation: Although the concept of inflation does not play a role in the analysis of the cost of a loan, the marketwide expectation of inflation during the term of the loan will have an impact on the interest rates charged by lenders. This is because lenders will always demand that the rate of interest paid exceed the expected rate of inflation plus their lending costs plus a rate of return (i.e., profit).

Definitions of Relevant Terms

Before any decision can be made, one must fully understand the question. To help you understand, here are definitions of terms you'll often hear when you apply for a loan.

Loan Amount: Amount borrowed. Used in calculating payments due.

Interest Rate: "Rental rate" the lender charges for use of its money. Almost always stated as annual percentage rate.

Origination: The day the loan goes into effect and the money borrowed is given to the borrower. Also referred to as "closing."

Discount Points ("Points"): A point is 1% of the loan request amount. A discount point is an amount due by borrower at origination. So if two (2) discount points are due and the loan amount is $500,000, the amount due at origination (loan closing) is $10,000. In most cases, the lender will simply take the fee out of loan proceeds. The term "discount" is used because points paid up front typically result in a lower, or discounted, interest rate.

Compensating Balance: Amount of cash the lending bank requires borrower to maintain at lender's bank, typically in a savings account or certificate of deposit. The result is lower net proceeds to borrower (see below).

Commitment Fee: Amount of money due at origination to "reserve" available credit for borrower. Typically used for loans that do not fully fund at origination, but rather involve a commitment to lend up to a certain amount over a period of time, such as with a line of credit.

Example. You wish to borrow $200,000 today against real estate you own, but you'd also like the ability to borrow an additional $100,000 if and when needed. To provide this, the lender might charge you a fee to reserve the extra borrowing capacity. For example, let's say your bank charges you a commitment fee of 1% of the amount unfunded at origination but is available for you during the term. The commitment fee at closing would be 1% of $100,000 or $1,000.

Compounding: Frequency at which unpaid interest charged on a loan is added back to principal and thereby begins to also incur interest expense. The more frequent the rate of compounding, the higher the effective rate. For example, the effective rate of an 8% loan (8% is the simple interest rate, meaning compounding annually) compounding quarterly is 8.243% (monthly compounding is 8.3%, weekly is 8.322% and daily is 8.327%).

Maturity: Expiration date of the loan. At maturity, the loan agreement expires and any unpaid sums must be fully repaid.

Term: Length of the loan, typically stated in years or months. At the end of the term ("maturity"), the loan agreement expires and any unpaid sums must be fully repaid.

Term Debt: Type of borrowing that requires principal payments to be made in specific intervals over the term of the loan, such as monthly or quarterly. Most commonly used to fund the purchase of assets that have long productive lives and steadily decline in value over time such as automobiles, machinery, equipment and improvements to real property. Also, the principal balance is highest at origination and steadily falls over the term of the loan, and the borrower is not able to re-borrow on principal amounts paid during the term.

Revolving Debt: In contrast to a term loan, revolving loans typically are used to fund assets that rise and fall in value over time, such as accounts receivable and inventory. Unlike term loans, the outstanding amount may be paid down and drawn back up again, as needed. A line of credit is a type of revolving loan.

Working Capital: Money "tied up" in short-term assets and liabilities. Generally, it's the difference between:

a.   accounts receivable, inventory, other short-term assets and

b.   short-term liabilities such as accruals and accounts payable.

A quick equation for working capital is current assets minus current liabilities (excluding current portion of long-term debt).

Amortization: Referred to as an amortization schedule, which is how the loan is repaid. Can be days, months, quarters or years. A loan may be full amortizing (i.e., the principal is fully repaid over the life of the loan) or not fully amortizing (i.e., will require a "balloon" payment at maturity). Amortization also may be:

• "level payments of interest and principal," such as with a residential mortgage (i.e., $1,256.86 per month for 240 months, in which each payment is first applied toward unpaid interest due and then the balance allocated to unpaid principal), or
• "principal payments of x each period plus accrued and unpaid interest." Calls for principal plus interest amortization terms (as opposed to principal and interest). Results in a faster amortization of principal (i.e., faster payoff) and higher payments (interest and principal) during the early periods and lower payments in the later periods (as the principal balance declines and the interest due per period declines as a result).

Net Proceeds: How much money you really get from the loan. It's the loan amount less any fees, loan origination costs and compensating balances required.

How to Crunch the Numbers

Now that we better understand the basic concepts and terms, we're ready to analyze the loan offers and see which is the best deal from a strictly financial point of view. This entails running an IRR analysis on each.

The IRR calculation simply provides us with the internal rate of return of any series of cash inflows and outflows. When we borrow and repay money, we receive a sum of cash (an inflow) and then pay it back over time (outflows). The IRR method calculates the discount rate that makes the net present value of the set of cash flows equal to zero. The result, or discount rate, is basically the cost of the loan.

So, IRR analysis entails listing outflows and inflows of cash over time. The easy part is listing monthly payments due, because that is given to you by the lender. You also could calculate it for yourself (not a bad idea, just to check the lender's calculations), as we have done for this example. Also, in cases where a compensating balance is required (see definition above), it will be necessary to adjust periodic cash outflows (loan payments) by any interest you receive on compensating balances. But the tricky part can be getting initial cash inflow correct (i.e., the net proceeds - see above definition) and the final cash flow correct (i.e., be sure to include a return to the borrower of any compensating balances required).

Now, to illustrate IRR analysis of loan offers, let's place our example in the context of a case study.

Loan Analysis Case Study

You personally own your office-warehouse building (through a pass-through legal entity you control, of course) valued at around $1 million. You owe $450,000 against it, so you enjoy equity in the $550,000 range. Your spouse urged you to buy the building 10 years ago, despite your reservations, so she gets major points.

Rent from your business (you rent the facility to your business and have a written, arm's-length agreement between your business and the pass-through legal entity that owns your real estate) provides the funds for debt payments and all other real estate expenses.

You have debt outstanding in your business - a term note totaling $78,000 against trucks and equipment and a $250,000 line of credit that is nearly maxed out. Cash flow has been a little tight. Add to that the uncertainly in the economic environment, and you think it might be smart to add some liquidity (i.e., cash) to your business by borrowing against the equity in your real estate and paying down your line of credit a bit. Your line of credit has not been fully revolving - it's not actually being fully paid off during the times of year that working-capital needs are at their lowest - as is proper for a revolving line of credit that funds swings in working capital.

So you've obtained the following loan offers. Yes, you received bids from two additional banks besides your longtime bank. Here are the key terms:

	Bank A	Bank B	Bank C
Loan Amount	$400,000	$400,000	$350,000
Interest Rate	7%	8%	6%
Term/Amortization	36 months	36 months	48 months
Closing Costs	$250	$1,350	$5,000
Discount Points	0	1	2
Compensating Balance	$25,000	$0	$0

Key inputs for an IRR calculation are loan amount, interest rate, term/number of periods/loan amortization, net proceeds at origination (i.e., loan amount less costs), monthly payment and then any end-of-term cash flow inputs. For each loan offer, let's lay out the key inputs and calculate IRR (you'll need to place the inputs in your own spreadsheet or financial calculator).

Calculation of IRR for Bank A's Offer

Loan Amount: $400,000. This is the amount that must be paid back over the term and thereby used in calculating periodic payment amounts (i.e., amortization).

Term/Amortization: 36 months

Net Proceeds at Origination: $374,750. This is the actual amount received by borrower at origination of loan. Differs from loan amount because fees and expenses of the loan are deducted from the loan amount at origination. For Bank A's proposal, Net Proceeds at Origination is the loan amount ($400,000) less closing costs ($250) less the amount of compensating balances required ($25,000).

Monthly Payment: $12,319.59. Calculated by taking the monthly payment on $400,000 loan at 7% rate of interest, fully amortizing over 36 months ($12,350.84) less the cash generated by compensating balances ($31.25 per month at assumed savings account rate of 1.5%). Here's the calculation:

=    Regular monthly payment - (compensating balance x monthly interest rate received on

compensating balance)

=    $12,350.84 minus [$25,0001 x (1.5%2 / 123)]

¹ compensating balance

² interest rate received on compensating balance (annual)

³ number of months in a year (to convert annual rate to monthly)

=    $12,319.59

End-of-Term Adjustment: Cash flow at the end of the loan term (36th period) should be increased by $25,000 to account for return of borrower's $25,000 of compensating balances.

IRR for Bank A's Proposal: 7.75%

Calculation of IRR for Bank B's Offer

Loan Amount: $400,000

Term/Amortization: 36 months

Net Proceeds at Origination: $394,650 ($400,000 minus $1,350 minus $4,000)

Monthly Payment: $12,534.55

End-of-Term Adjustment: None

IRR for Bank B's Offer: 8.92%

Calculation of IRR for Bank C's Offer

Loan Amount: $350,000

Term/Amortization: 48 months

Net Proceeds at Origination: $338,000 (i.e. $350,000 minus $5,000 minus $7,000*)

* 2% of $350,000

Monthly Payments: $8,219.76

End-of-Term Adjustment: None

IRR of Bank C's Proposal: 7.8%

So now you have the true cost of each loan calculated by IRR. Here they are:

Bank A:       7.75%

Bank B:       8.92%

Bank C:       7.80%

Which should you take? Well, if the only criterion were absolute cost, the answer would be Bank A. In this case, that's a good thing because Bank A is your longtime bank and you are certainly partial to it. But you also might give good consideration to other things, such as the longer amortization schedule offered by Bank C. This results in lower monthly payments, which helps cash flow. But Bank C's loan amount is also $50,000 lower than the others. How valuable is the extra $50,000 available from Bank A and Bank B?

As is often the case, the decision rarely comes down to price alone. But price matters. Cost matters. It's a vital input into any well-thought-out decision. So the next time you go for a loan, crunch the numbers. Calculate IRR for each option and at least have the benefit of the hard financial data.

Discount Points Break-Out

Discount points ("points") typically serve as a kind of prepayment of interest that will eventually be due on a loan. As such, they serve to reduce (often referred to as a "paying down of") the interest rate on a loan. Many times, borrowers will be given a choice of how many points they wish to pay at origination. It's basically a question of whether you'd like to pay a larger expense at origination and thereby lower the interest payments that will be due later, or pay less at origination but more over the term. When given a choice, the first thing to do is calculate the effective interest rate for the loan.

Here's a simple example:

Loan Amount:                         $200,000

Loan Term:                              3 years

Frequency of Payments:         monthly

Closing Costs:                         $500

Interest Rate and Points:        Option 1: 8%, no points

Option 2: 7%, 1 point

Option 3: 6%, 2 points

Analysis Method: Internal Rate of Return (IRR)

Option 1: IRR = 8.17%

Note: Loan Amount is $200,000; Net Proceeds are $$199,500 ($200,000 less the                           $500 closing cost).

Option 2: IRR = 7.85%

Note: Loan Amount is $200,000; Net Proceeds are $$197,500 ($200,000 less the                           $500 closing cost less 1 point or $2,000).

Option 3: IRR = 7.53%

Note: Loan Amount is $200,000; Net Proceeds are $$195,500 ($200,000 less the                           $500 closing cost less 2 points or $4,000).

Note that if the loan term is one year, the discount points coupled with the short amortization cause the effective cost (IRR) to rise considerably:

Option 1: IRR = 8.47%

Option 2: IRR = 9.37%

Option 3: IRR = 12.28%

What's the message? Get various loan proposals from your banker, calculate the IRR for each and use the results in your calculations.