3 Lenders, Same Rate But… 3 Different Interest Costs?
Most will understand that the lender’s headline interest rate is designed to get your attention but comes with some form of caveat.
Lenders do it because they know one thing works: most prospective borrowers select their lenders, at least initially, according to who has the cheapest looking interest rate.
The bad news is it’s probably costing you a lot of money.
Delving deeper into how interest rates work can not only save you thousands in finance costs, but also greatly affect which lenders you may or may not approach.
One truth about the marketplace is this:
The cheapest looking lender is rarely the cheapest in practice.
To understand this concept, let’s work an example:
You’ve shortlisted 3 lenders and they all have the same interest rate (let’s pretend other fees are constant for now). The rate is 7% p.a.
However, when you get their offers, or term sheets back, you find that, in Pounds and Pence, the amount of interest differs markedly between all three, ranging from £430k to £700k.
How can that be?
There are 3 different ways the interest rate can be applied:
- on the total facility
- on the running total, or drawn balance
- projected based on a private equity IRR model (this requires a certain return to be made)
These different models give you different amounts of interest.
Next comes the Cashflow Model..
On top of the varying interest rate models, your shortlised lenders can also be using different cashflow projections too.
A variety of models exist, from the S-Curve Model to equal drawdowns and finally your cashflow scheule if you have provided one. Most lenders aren't using your cashflow model, and are therefore unintentionally predicting interest incorrectly.
If lenders are using different rate applications, and using different cashflow models, how can they be comparable to each other?
Getting this wrong can make the projected interest unrealistically low or high, and can unintentionally affect your decision making when it comes to selecting a lender.
Ultimately you need a constant: the interest rate acts as a starting point but really it is the cashflow that must be the constant, even if it is projected and will change in reality. The best way to ensure you are comparing apples with apples is to make sure you have done a cashflow schedule, however basic, and that the shortlisted lenders have all used your model, so you can compare.
You may be surprised to see how much the interest projection changes, for good or bad!
So hopefully you can see how not delving further into the interest rate, and the utilised cashflow model, can cost you money, and this is before we’ve even looked at fees.
With regards fees, it is not uncommon if you get it wrong for interest to only account for 50-60% of your total finance costs!
If you would like to know more about how to keep your finance costs down, download our free report on slashing up to 50% off your finance costs as below.
Chris Davidson is Managing Director of Discover & Invest Ltd, a specialist development finance brokerage and operator of the Discover Development Finance website.
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