How do you compare loan offers: the interest rate or the all-in cost?

Why the quoted rate misleads

A quoted rate tells you what the money costs per year while it is outstanding. It says nothing about what you pay to get the money, what you must leave on the table while you have it, or what you pay to give it back. Lenders price a loan as a package. One lender takes its return mostly through the spread; another quotes a thinner spread and earns the difference through an upfront fee, a rate floor, a deposit requirement or call protection. Both can reach roughly the same return for the lender. For the borrower the two are not the same loan.

The quoted rate also hides the index. A loan priced over SOFR and one priced over prime can show spreads that look far apart and land in the same place, or show similar spreads and land in different places. Convert every offer to the same thing before comparing: the total cash you expect to pay the lender and third parties over the time you expect to have the loan, against the money you actually get to use.

Put every offer on the same all-in basis, over the same expected hold period, before the rate enters the conversation.

What goes into all-in cost

Some of these are obvious because they appear as a line in the term sheet. Others appear only in the loan agreement or in how the loan is operated. A required hedge is a separate contract with its own cost. A requirement to move all operating accounts to the lender may cost nothing, or may cost the interest you were earning elsewhere. Reporting requirements, such as an annual reviewed or audited statement, are a real annual expense that belongs in the comparison.

A worked comparison over the hold period

Take two offers on a term loan of 2,000,000. To keep the arithmetic clear, ignore amortization and treat the balance as constant. Amortization only shrinks the yearly interest difference as the balance falls, which pushes the break-even for the lower-rate offer later still.

• Offer A has the lower rate: interest of 150,000 a year. It charges 50,000 at closing, requires a rate cap costing 30,000, the borrower pays 25,000 of the lender's legal costs, and repaying in the first three years costs 20,000.
• Offer B has the higher rate: interest of 160,000 a year. No closing charge, no hedge, 15,000 of the lender's legal costs, and no penalty to repay.

Offer A's rate advantage only pays for its upfront costs if the loan stays in place for most of a decade. If the business expects to refinance once earnings grow, to sell within a few years, or to pay the loan down from a cash sweep, Offer B is the cheaper loan despite the higher rate. The same arithmetic is the core of any refinance break-even: upfront costs divided by the annual saving gives the number of years before switching pays.

The hold period is the assumption that decides it

Most business loans do not run to maturity. Acquisition loans are refinanced when the company has paid down enough to borrow on better terms, or repaid when the business is sold. Lines of credit are renewed, re-sized or moved. Private credit is usually refinanced once the company qualifies for cheaper senior debt. So the useful horizon is the one you expect, not the one printed on the note.

Be honest about that horizon. An owner planning to sell in three years should weigh upfront fees and exit terms heavily. A buyer taking a long SBA 7(a) acquisition loan with no plan to refinance can give the rate more weight. Where the horizon is uncertain, run the comparison at two or three hold periods, as above, and see whether the answer changes. If it changes, the exit terms are worth negotiating before anything else.

Items borrowers most often leave out

Prepayment terms. A step-down penalty, a make-whole or yield maintenance clause, or a flat exit fee can outweigh years of rate difference. On 7(a) loans with a maturity of 15 years or more, SBA's own rule applies: prepaying more than 25% in any of the first three years costs 5% of the prepaid amount in year one, 3% in year two and 1% in year three. Many conventional and private loans carry their own terms; see prepayment penalty structures.

Hedging. Lenders often require floating-rate borrowers above a certain size to fix or cap part of the rate. A cap is paid for upfront; a swap has no upfront price but carries a cost to unwind if rates have fallen and the loan is repaid early. Either way it belongs in the comparison. See hedging requirements and swap vs cap.

Unused and deposit terms on lines. On a revolver, the unused-line fee is paid on what you do not draw. A line sized well above average usage can cost more in unused fees than a smaller, fully used line costs in interest. Compare lines on expected average usage, not the limit. See unused-line fees and how revolvers are priced.

Rate floors. A floor sets a minimum index. When the index sits below the floor, the borrower pays the floor, so the quoted spread understates the rate.

Amount actually funded. Fees netted from proceeds, reserves the lender holds back, and original issue discount all reduce the money you get while the full amount is repaid. Divide the cost by the net amount, not the face amount.

What cost cannot capture

Some differences between offers do not have a price but still matter. Covenant terms decide how much room the business has before a bad quarter becomes a default; a loan that is cheaper but trips its covenants in the first soft year is expensive in a way no spreadsheet shows. See covenant headroom. The amortization schedule changes cash flow, not cost: a longer amortization lowers the annual payment and leaves more cash in the business. The size of the personal guarantee, the collateral taken, and whether the lender can call or freeze a demand line all belong in the decision beside the all-in cost.

The fair comparison is therefore two steps. First, put every offer on the same all-in cost over the expected hold. Second, weigh what is left: covenants, amortization, guarantee and flexibility. The first step is arithmetic and should be done the same way for every offer; the judgement belongs in the second.

How to get offers you can compare

Offers are only comparable if they answer the same request. When lenders see different figures, different uses of proceeds or different structures, their terms differ for reasons that have nothing to do with price. Sending every lender the same package, with the same financial model and the same request, is what makes the answers line up. That is the purpose of the lender package: once a borrower's documents are in, Transparent builds the financing model, lender presentation, blind teaser and underwriting memo in a day, and every lender prices the same file.

When the offers come back, ask each lender for the items in the table above in writing, including an estimate of third-party costs and the full prepayment schedule. A term sheet that is vague about fees is not yet an offer you can compare.