Term vs. Rate: Which is More Important?

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Loans can be complicated. There are a lot of factors to look at when analyzing a loan offer; the term, rate, payment structure, pre-payment penalties, collateral, etc. In this article, we are going to talk about two of the more common things that successful franchisee’s focus on when evaluating a loan offer. The term and the rate.

When we say the “term” of a loan, we are talking about the length of the loan and how long the lender is giving you to pay the loan off. A longer term can be nice to spread out your payments over more time and subsequently make the payments smaller. However, a longer term typically means you will end up paying more money in interest of the life of the loan. The right term various based on the business and what is actually being financed. If the equipment being financed has a very short life span, you should try and get a shorter term so that you aren’t paying off the equipment long after the equipment is obsolete.

When we say the “rate”, we are referring to the interest rate tied to the money. This should be seen as the cost of borrowing. It is the cost that you are incurring to borrow the amount of money to grow your business. The lower your rate, the less expensive the money is to borrow and the less you will pay over the actual value of the item you’re financing.

Now, the important question we here a lot: Which is more important to focus on when getting a loan, the term or the rate?

Franchisee’s more commonly fixate on the rate of the loan. They see a rate and get sticker shock because they can get half a percentage point cheaper at different lender. However, there are cases in which focusing on the term of the loan is actually the smarter financial decision. The focus on the term vs. the rate depends on each business model and how much you can afford per month.

For example:

If you were to borrow a loan for $100,000 at a 3% APR for a 3 year term, your monthly payment would be around $2900. However, if you were to borrow $100,000 at a 6% APR over 7 years, your monthly payment would only be around $1460. The key thing to keep in mind here is whether you can afford the monthly payment or not. If you can stick it out for 3 years and make the $2900 payment each month, you will end up saving money in the longer run. However, many franchisees could not afford a monthly payment that high and so going with a little bit of a higher rate over a longer term is more feasible and will still get the job done. Determining what monthly payment you can afford before taking out a loan is important, but sticking to the budget is the hard part and that is where we see franchisee’s make mistakes and take on a loan that they can’t afford the monthly payment.

We’ve talked about cash flow and liquidity in previous articles, and here is yet again another place where it is so important. Knowing how much cash you have on hand to make monthly loan payments is the first step to determine before you go looking for a loan.