The Real Cost of Borrowing

Features - Finance & Accounting

Calculate the cost of all available loan options so you’re in a position to make a smart borrowing decision.

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September 3, 2019

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Small business lending has taken a significant blow over the past few years. Lower interest rates have translated into lenders being more selective. Fortunately, with many larger businesses reducing their borrowing needs after the initial buying spree that resulted from the tax write-offs generated by the Tax Cuts and Jobs Act (TCJA), there is increased attention on small business lending.

Still to be answered, however, is all-important question of what it actually costs to fund the operation or the expansion of the snow removal or ice management business?

THE HIGH COST OF MONEY

Although often overlooked, two factors impact on how much a business loan will cost: the interest rate charged and the fees required before, during and after the loan process. They combine to create the annual percentage rate (APR), which is the cost of the loan every year a balance remains.

The type of loan needed by the professional snow removal or ice management contractor that also affects the interest rate charged. Unfortunately, all-too-often the interest rate stated by lenders does not reflect the true cost of a loan. The loan agreement may require borrowers to maintain compensating balances and pay a number of fees.

Among the most common fees include:

Packaging fee. When applying for a loan, borrowers are usually required to provide a lot of information about the snow removal business, its finances, etc. all of which generally needs to be backed by a great deal of documentation. Whenever assistance is received from a third-party or even from the lender in completing the loan application, the applying business may be charged by the third-party or the lender, a fee for assembling the required documentation.

Processing/Application fee. A credit check of both the owner and the business as well as perhaps a personal background check are often required. All of this information is gathered and processed by lenders to ensure the application package has everything needed to analyze the probability of timely repayment. The processing fee compensates the lender for the time, work and expertise required to complete this analysis.

Underwriting fees. Once a loan application package is complete, it normally goes to the lender’s underwriting department, where it is studied to verify all information provided is true. The lender also assesses the risk it would be taking by approving or denying 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 loan includes a real estate transaction, the lender will certainly incur closing costs that may be absorbed by the lender or the seller in order to encourage the sale.

Maintenance or servicing fees. These are fees 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 snow removal business/borrower usually reimburses the fee the lender is required to pay to the SBA. Similar to “points,” this 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.

THE COST OF BORROWING

In addition to this wide range of potential fees, the loan agreement may require the borrowing snow removal and ice management business to maintain “compensating balances,” pay a “commitment fee” or the loan may be “discounted.”

And these are only the more frequently encountered terms:

Discounted loans. When a loan is discounted the interest is subtracted from the total amount of the loan. Thus, the proceeds received by a borrower, and available for use, represent the difference between the face amount of the loan and the amount actually available. Discounted loans are usually short-term loans.

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 snow removal business, pays interest on the entire loan.

Doubling up. Surprisingly, a snow removal business could find itself subject to both requirements, that is, the loan could be both discounted and compensating balances required.

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.

LOST OPPORTUNITY COST

Before shying away from borrowing, every snow removal professional should remember that there are costs associated with not borrowing. One common misconception is that using savings and investments to finance needed purchases or to keep the business going, saves on finance costs.

Consider the contractor who lends his or her own funds to the snow removal 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 earned by savings might substantially reduce that lost opportunity cost, but it remains a factor for consideration.

Another, frequently overlooked cost to not borrowing is that the 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.

THE NEW LIMITED DEDUCTION FOR BUSINESS INTEREST

Many snow removal professionals are discovering they are unable to deduct business interest expenses. No longer deductible are business interest expenses that exceed 30 percent of the adjusted taxable income of the business. Or, that exceed the sum of business interest income, and the floor-plan financing interest of the business.

For snow removal businesses operating as S corporations, partnerships and limited liability corporations (LLCs), that are treated as partnerships for tax purposes, the limit is applied at the entity level rather than at the owner level.

Fortunately, the new 30 percent limitation does not apply to some small businesses such any operation with average annual gross receipts of $25 million or less. What’s more, any business interest that isn’t deductible in the current year because of the limitation is treated as business interest incurred in the following tax year. This excess may be carried forward indefinitely.

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DEBT VERSUS EQUITY FINANCING

Borrowing isn’t the only way to finance the snow removal business. In order to expand, grow or even exist, many snow removal and ice management professionals find it necessary to tap a variety of financial resources, usually falling into two categories, debt and equity. "Debt" involves borrowing money to be repaid, plus interest, while "equity" involves raising money by selling interests in the business.

Which alternative is the most economical, debt or equity financing? According to a report issued by the Joint Committee on Taxation (JCT), “the after-tax effect of debt financing is more favorable than equity financing because of the deductibility of interest.” That’s right, when it comes to managing debt, the interest paid on borrowed funds -– even with the TCJA’s business interest limited deduction — is deductible by a business borrower, while funds directed to equity investment are not.

According to the JCT report, “A taxpayer may have an incentive to incur debt so that deductible interest expense, in combination with other deductions such as depreciation or amortization, may shelter or offset the taxpayer’s income,” it said. Naturally, the TCJA’s business interest deduction ceiling must be a consideration.

COME AND GET IT

Now might be a good time for every snow removal professional to perform a cost/benefit analysis. A Cost Benefit Analysis is a decision-making tool often used in making financial decisions. As the name implies it weighs the costs against the benefits of the decision.

Whether already available, or more readily available, thanks to the Federal Reserve’s pumping more funds into the marketplace, business loans can and will vary by lender and amount. Shopping around to both find a willing –- and an affordable –- lender involves looking at more than the interest rate.

Due to the recent uncertainty of state and federal tax rates, along with healthcare costs, many snow removal and ice management professionals have taken a “wait and see” approach when it comes to decisions about expansion, acquisitions, and financing. With higher interest rates and inflation on the horizon everyone needs to consider the cost of borrowing or inaction.

Obviously, taking out a business loan is a big step in today’s uncertain economic climate. However, by calculating the cost of all available loan options, every professional will be in a position to make a smart borrowing decision that will help the snow removal and ice management business grow and prosper for years to come.

Mark E. Battersby is a financial writer based in Ardmore, Pa; and is a frequent Snow Magazine contributor.