This is all about the cost of borrowing money and how interest rates can be misleading. Let’s start with a simple question;
If you borrowed £200 at Wonga’s interest rates (as 2011) then how long would it take before you owed the same as the US national debt of $16 trillion?
The maths behind this is really basic and have some faults, but let me try humour you. Working on an APR of 4,000% then after 6 years your £200 would have risen to £819,200,000,000 that is £819 billion. After 7 years this becomes £32,768,000,000,000 that is £32 trillion.
Somewhere in year 7 you exceed the US national debt.
Cost of Borrowing Explained
This Wonga example is fundamentally flawed. Firstly Wonga won’t lend over a 6 or 7 year period, it is all short term. In the same regard because they lend on a short term basis an APR itself is largely irrelevant. 4,000% APR works out as circa 40% per week, so if you borrow £100 until next week then you pay a £40 fee.
This is where APR falls down and why some lenders want to express interest cost as a daily, weekly or monthly percentage figure. Sometimes this can be far more reflective of actual cost than the approved standard APR.
How To Work Out If Borrowing Is Worth it
This is always an interesting one. When does it become worthwhile to borrow money? Lime Consultancy say that you must be borrowing (when a business) for one of three reasons,
- To make money
- Save money
- Otherwise benefit your business
So long as you can save more by taking the borrowing, make more money than you are paying in interest or see the benefit of what the borrowed cash will bring as being worthwhile then the cost of business borrowing can be much less important.
This is explained a little more in this video;
If you are thinking of borrowing then my recommendation would be to;
- Think of why you are borrowing before looking at the cost
- Think of the benefit to borrowing ahead of what it will cost
- Compare apples with apples
Comparing Apples With Apples
There is a tendency for business owners to compare the cost of one lender with the cost of someone completely different. Let me use an example of a recent conversation;
“The cost of this finance is too high, it works out at almost 40% per annum. My bank would lend this to me at less than 10%, is someone trying to rip me off?”
The answer is ‘no’. In this scenario the client’s bank had declined to lend, the business was loss making and the business owner did not want to provide any security. Therefore comparing a lender that will lend against the costs of one who doesn’t want to lend makes no sense.
If you are going to compare the cost of finance then make sure you compare like with like, apples to apples.
If you are unsure if any interest rate you are being quoted is realistic then please ask, I am always happy to give the benefit of experience.
By Dave Farmer
Dave Farmer is founder of the award winning Lime Consultancy. A business finance and commercial funding specialist.