When taking on financing as a small business, the correct course of action always hinges on answering this question: what am I trying to accomplish?
The thing is, financing decisions don’t exist in a vacuum. Small businesses often miss the vital details when assessing whether to borrow or not, such as the full financing cost, the drain on their time, the opportunity costs and baked-in fees.
The right financing option varies for every company, but there are five areas where I see small businesses frequently make financing mistakes. Here are the common pitfalls and the best ways to avoid them so your small business can choose the best option at each stage of your company’s growth.
Related: How to Raise Money for Your Business
1. Be aware of your real interest rate. Surprisingly often, people who think they know how to calculate interest rates often don’t. I even see journalists from major national newspapers frequently get it wrong.
For example, if you borrow $1,000 and pay $1,100 back over three months on weekly installments, your interest rate wasn’t 10 percent, as simple math would dictate. Taking a closer look at the timeframe for the note and your average principal outstanding reveals that it’s actually closer to 80 percent. That’s a difference of 70 percentage points in your financing cost.
This mistake happens because most businesses simply calculate APR as total fees divided by the amount borrowed, rather than calculating the interest based on the amount outstanding at every point in time (i.e. the amortized amount). The difference is massive for small businesses as financing mistakes are compounded. In the example above, the actual annual rate is eight times higher than the optical.
2. Pay attention to hidden fees. When taking out financing you must take into account origination fees. Many lenders charge origination fees of 3-4 percent, which are deducted from the loan amount. Depending on how quickly you pay that loan back, that fee can have a large impact on the true interest rate you’re paying.
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