22 Jun How effective is your rate?

By David Robinson

How do you know that you have a business loan that is competitive in today’s market? Is comparing the loans advertised interest rate the best way to compare the cost of business loans?

Like comparing fuel efficiency of vehicles, the only way to accurately compare any good or service is to have a uniform measure so that you are comparing “apples with apples”.

It is the same with business loans.

Comparing the advertised nominal interest rate is not an accurate measure to compare the true cost of the many different loan products across all the various banks. This becomes even more diluted when you have multiple loan products in your business lending portfolio. To accurately compare the true cost of your business loan portfolio, you need to compare its effective rate compared to the market alternative.

The rate that you generally see advertised and quoted on your business loan contract is the nominal rate. The nominal rate is the loan interest rate expressed as an annual simple interest rate. This rate does not capture the true cost of the loan and therefore should not be used when comparing loan products and loan portfolios.

The effective rate (or annual percentage rate) is the true annual interest rate that takes into account compounding (i.e. interest charging and loan repayment frequency), additional loan fees and loan utilization rates. The effective rate calculates the true cost of a loan (or loan portfolio) and is the best way to compare the true cost of loan products and alternate bank loan packages.

When calculating the effective rate, it is best to compare loan structures that will best replicate your own utilization rate (i.e. on average how often is the loan fully drawn) and repayment capacity (i.e. over what timeframe will the loan be paid out).

For example, refer to the table below;

If we were to compare the nominal interest rates for an overdraft facility and a term loan, we notice that Bank 1 has the lower rate for both loan products. However, it would be wrong to conclude that Bank 1 has the best loan package in terms of cost efficiency because it has the lowest nominal interest rates. This rate does not consider the associated product loan fees, utilisation rate of the loans and the amortisation schedule of the term loan. To determine which bank has the most cost-efficient package, the effective rate for each loan package needs to be calculated.

The below table summarises the effective rate of the loan package between the 2 banks, based on various scenario assumptions:

1. Term loan is interest only for 1 year, both term loan and overdraft are fully drawn for 1 year
2. Term loan is interest only for 1 year, both term loan and overdraft are 70% drawn for 1 year
3. Term loan is amortised over 10 years, both term loan and overdraft are fully drawn for the 10-year period
4. Term loan is amortised over 10 years, both term loan and overdraft are 70% drawn for the 10-year period

It is also assumed that the nominal interest rate is also unchanged over the respective loan terms.

In this example, calculating the effective rate of the loan portfolio over a 1-year term is the same for both banks, even though the loan products had different nominal rates. Once fees were considered, the loan portfolio effective rate is the same for both banks. This comparison is only valid if the loans was to be paid out after one year. Given that term loans are deemed to be repaid over a longer timeframe, an effective rate that incorporates both amortisation and utilization is a better measure of the cost efficiency of a loan portfolio.

Just by incorporating the assumption that, on average, the loans are only drawdown to 70% of their loan limits, the effective rate between the 2 banks starts to diverge, with Bank 2 having the lower effective rate. The divergence is primarily due to the difference in bank fees between the 2 banks. Loan fees are essentially a “fixed cost” to the overall cost of the loan portfolio and are payable regardless of loan balances. Bank 1 has lower nominal interest rates, but higher line fees compared to Bank 2, resulting in higher overall cost due to the relatively higher fixed costs as the term loan balances reduce over time.

Incorporating amortisation and utilisation diverges the effective rate between the 2 banks even further. In this example, the difference in the effective rate is 1.61%. In money terms, this is a difference of approx. $200,000 over a 10-year period!

In summary, comparing loan nominal interest rates is not an accurate methodology to evaluate the true cost efficiency of loan products. In order to obtain a more robust comparison, the effective rate of the loan product or loan portfolio needs to be undertaken.