When you need a commercial loan, you check interest rates. That may even be the deciding factor when it comes to choosing a lender. But there could be more to the story. Depending on the loan agreement, the interest rate you agree to pay may be only part of your total cost of borrowing.
Lenders sometimes require borrowers to deposit a portion of their loan amount in an account with the bank to help ensure payment. For example, if you borrow $10,000, you may have to leave $1,000 in an account at the bank. You’ll be paying interest on the whole loan, but you can only use $9,000, which effectively increases the amount you’re paying to borrow the money.
In a discounted loan agreement, the borrower is required to pay the full amount of interest up front. So, in a simple example, if you borrow $10,000 at 12% interest for one year, you’ll owe the bank $1,200 and walk away with a net amount of $8,800. Again, the bottom line cost of a discounted loan is more than the stated interest rate.
A commitment fee is what banks charge borrowers on the unused portion of a line of credit. Back to the example: Your loan is for $10,000 at an interest rate of 12%. Initially, however, you take only $7,000. Unless other terms are in place, you pay interest on the amount you borrow and a commitment fee on the unused portion of $3,000.
OR A COMBINATION
Lenders also may combine these requirements, which can result in a fairly complex loan agreement. Before you sign the contract, make sure you understand the terms and the costs involved.
It is always a best practice to involve your CPA before signing any loan covenants.