Understanding borrowing costs: APR vs factor rate

The four ways cost gets quoted

Annual percentage rate spreads interest and compulsory fees across the life of the facility as one annualised figure. A margin over a reference rate quotes only the spread, so the true rate moves with the benchmark. A factor rate multiplies the amount borrowed by a fixed number, so borrowing one hundred thousand at one point two means repaying one hundred and twenty thousand. A flat fee simply charges a percentage of the amount advanced.

None of these is dishonest by itself. The problem is comparing across them, because a factor rate says nothing about the term and a flat fee says nothing about how quickly the balance amortises.

Why term changes everything

A factor rate of one point two repaid over twelve months is roughly a thirty five to forty per cent annual cost once you account for the balance reducing as you pay. Repaid over six months, the same factor rate is far more expensive in annual terms, even though the total repaid is identical.

This is why short term products with modest looking total costs are often the most expensive money in the market. Always convert to an annualised figure using the actual repayment schedule.

Receivables and asset facilities

Invoice finance combines a service fee on turnover with a discount charge on funds drawn. The service fee is not interest, so ignoring it understates the cost badly. Add both, plus any minimum fee, audit charges and termination cost, then divide by the average funds actually in use.

Asset finance is usually quoted as a monthly rental. Convert it by comparing total rentals plus any option fee against the cash price of the asset over the term.

The fees that hide outside the rate

Arrangement and commitment fees, non utilisation charges on undrawn revolvers, valuation and legal costs, early settlement penalties and exit fees all belong in the comparison. On a two year facility an arrangement fee of two per cent adds roughly a point a year to the real cost.

Build one comparable number

Take the total of every payment you will make over the expected life of the facility, subtract the amount received, and express the difference as an annual percentage of the average balance outstanding. Do it for each offer on the same expected life. The ranking that produces is the only one worth acting on.

Then look past cost at flexibility. The cheapest facility is a poor choice if it cannot grow with the business or carries a penalty for repaying early when the position improves.