The cost of credit: Key terms to consider
Don't forget to review all the associated rates and fees before applying for business credit.
When seeking credit, there are multiple things to consider, and deciphering the terms is a good place to start. There are various items that add up to the cost of credit — both obtaining it and paying it off.
If you understand the terms you can gain a deeper understanding of the true cost of credit.
Cost of credit #1: Interest rates and grace periods
Credit products tend to have either a fixed or a variable interest rate.
A fixed rate is set when the credit is approved and will not change during the term, unless you default. Calculating the cost of interest beyond the principal is complex and involves many variables, so we suggest using a repayment calculator for a clearer idea of the true cost of interest rates over time.
A variable interest rate changes over the life of a loan. Loans linked to a varying "prime rate" (currently standing at 3.5 percent) are typically referred to as "prime plus" loans, meaning that the interest rate is determined by taking the "prime rate" (commonly set by the lender in relation to the federal funds rate, which is the overnight rate at which banks lend to one another) and adding an additional percentage (or spread) set by the lender.
If you pay off your credit card's previous statement balance in full during the "grace period" — the time between the end of the billing cycle and the payment due date — you won't have to pay interest on your new purchases. Keep in mind that if you carry an unpaid card balance from month to month, you may still be charged interest. In addition, "cash advances" typically bear interest from the date of the advance no matter what (there is no grace period on cash advances).
Cost of credit #2: APR, finance, and origination fees
Annual percentage rate (APR) of a loan is the total finance charge, including interest and fees, expressed as a yearly rate for consumer credit. Business purpose credit typically refers to an "interest rate," not to an "APR."
Finance charges and origination fees refer to a wide variety of additional costs of obtaining credit. Other types of fees include application fees, documentation fees, notary fees, recording fees, and brokerage fees. Origination fees are mostly associated with real estate transactions and represent a relatively small percentage of the loan amount (usually .25% to 2%).
It's important for a borrower to investigate all fees and charges in detail by carefully reading the customer agreement and disclosure statement (if any) and loan documents.
Cost of credit #3: Loan duration
Loan duration refers to the amount of time you have to pay back the loan. On the surface, a longer-term loan will cost less on a month-to-month basis for businesses concerned with cash flow. However, lenders generally give better interest rates on short-term loans, because they will be paid back sooner, and so the amount you pay over the life of the loan can be less for a short-term loan with a fixed rate than a long-term loan with a fixed rate.
For example, the monthly payment for a 30-year loan may be smaller than for a 15-year loan, but the overall cost of the loan will be higher, due to the total amount of interest paid.
Cost of credit #4: Late fees and over-the-limit penalties
If you don't make the minimum required payment by the end of the payment period, you will be charged a late fee. To avoid additional penalties, the overdue amount and late fees must be paid in full with your next payment. In addition, if you repeatedly fail to pay the required payment on time, the lender can usually raise your interest rate.
If you are approved for either a credit card or line of credit, but spend more than the amount you are approved for (referred to as going "over-limit"), you might accrue additional penalties, as laid out in your financing agreement.
Understanding all of these potential costs can help you make the right credit choices to meet your needs. Doing research up front can save you headaches, time, and — most importantly, money — in the long run.
Use our Business Credit Quiz to expand your business credit knowledge.