Although there are more loan options available today than ever before, accessing borrowed capital is still a challenge for many small business owners. How do you know which loan, or lender, will best suit your loan purpose? How do you understand the costs of financing? What are the fees? What is APR vs. Total Cost of Capital vs. Cents on the Dollar? And, what happens if I want to pay my loan off early?
These are all questions you should be asking yourself, and your lender, before you sign on the dotted line.
Transparency Then and Now
Not too many years ago when a small business owner needed to borrow, he or she would head down to the local bank where they had their business checking account and sit across the desk from a loan officer and complete a business loan application. Although the interest rates at one bank might be different from another, the terms were similar, and they were all expressed in an Annualized Percentage Rate (APR), which made it pretty easy to compare their options.
The cost of financing was reasonably transparent.
Today, a small business has a lot more options. In addition to a traditional term loan from the bank or an SBA loan, depending on their business need, they could choose from an online loan, a Merchant Cash Advance (MCA), online factoring, leasing, short-term financing, long-term financing… you get the point.
All the different loan products, and the different lenders, now have different ways of expressing the cost of financing, which can make it challenging to understand the costs and make informed choices?
The SMART Box Initiative
I don’t think the differences in how they express cost is an effort to be misleading, in most cases it’s simply the nature of new loan approaches. For example, a six-month term loan is decidedly different than a 10- or 30-year loan and sometimes comparing them with the same metrics doesn’t give the small business borrower enough information to make an informed choice.
That’s why, in May of 2016, a few of the largest online small business lenders, (including OnDeck) and a leading national non-profit microfinance trade association decided to do something about it. This group started working together to create what they call, “Straightforward Metrics Around Rate and Total cost—SMART Box,” to foster common verbiage and enhanced disclosure standards around a comprehensive set of pricing metrics.
The goal wasn’t to replace the current disclosure, but is rather intended as a supplemental disclosure that identifies key pricing information in plain English so borrowers can better compare different loans or different loan types. The SMART Box offers a disclosure approach that will make it possible for a small business owner to compare different loan products to determine which will be the best fit for the business’ use case.
What are the SMART Box Metrics?
Some of the SMART Box metrics will be more familiar than others, but I’m convinced they all play an important role that will enable borrowers to make apples to apples comparisons when evaluating their loan options.
In addition to some pretty basic considerations like amount borrowed, payment frequency and amount, and the term of the loan, the SMART Box metrics include:
- Annualized Percentage Rate (APR): This metric provides the cost of capital—including fees that are a condition of receiving the capital. APR can be a good comparison tool when comparing loans of similar term (think home mortgage or auto loan), nevertheless it is not the interest rate applied or used to calculate the total dollar cost of the financing option. Navigant Consulting will validate that lenders using the SMART Box are using APR calculations consistent with the principles of Regulation Z (implementing the Truth in Lending Act).
- Total Cost of Capital (TCC): This metric will include all interest and any other fees that are a condition of receiving capital. This metric discloses the total dollar cost of the finance option, a crucial source of information for a small business owner borrowing for a use case that includes a defined ROI.
- The Average Monthly Payment: This metric will reflect the average monthly cash flow impact of repaying the finance option being considered. Regardless of whether the periodic payment is daily, weekly, or monthly, the average monthly payment provides a common benchmark for evaluating monthly cost.
- Cents on the Dollar: This metric identifies the amount of interest (or Loan Fees, as applicable) paid for every dollar borrowed. This metric is exclusive of all other fees to allow for comparison with other common pricing metrics in commercial finance, including the factor rate, simple interest, and total interest percentage.
- Prepayment Conditions: The SMART Box identifies whether there will be additional fees or charges for prepayment and what they may be. It also identifies if prepayment will result in any reduction in interest or applicable loan fee. This is intended to make any applicable prepayment policy readily transparent to the borrower.
The SMART Box disclosure assumes that the finance option will be repaid in its entirety according to the terms of the applicable agreement and that no payments will be missed.
What Does this Mean to You?
As a small business owner, you now have a tool to help you compare different loan types to determine if it’s a good fit for your business. Participating lenders will include the SMART Box disclosure within their loan documentation, but even if the lender you’re working with doesn’t include the disclosure, you should be asking these questions to get a complete understanding of what the costs and terms are associated with the loan you may be applying for.
Today’s landscape requires a more savvy approach to small business borrowing and you’ll need to start the process armed with the information you’ll need to make smart decisions. Borrowing to meet a short- or long-term need may require a different financing approach. And, borrowing to fuel growth, cover a cash flow gap, bridge a slow business season, or some other business need might justify different loan costs. Today, many loan options are tailored to specific business use cases so it requires that you, the business owner, better understand the total costs associated with borrowing, the payment terms and frequency, and the other metrics identified in the SMART Box—in addition to the anticipated APR.
This is the first time leading small business lenders collaborated on the best way to make small business lending more transparent, and I’m proud of the role OnDeck played in this. The goal is to make it easier for small business owners to actually compare small business loans.
If you’d like to learn more about the SMART Box initiative, visit the Innovative Lending Platform Association.