How Banks Hide the True Cost of Your Business Loan

by | Jan 30, 2023 | Resources | 0 comments

How Banks Hide the True Cost of Your Business Loan

If you’re a small business owner, you need to know about how banks use the annual percentage rate (APR) to scam borrowers. Let’s be honest… does anyone REALLY know what an APR is? In 15 minutes of searching on Google, I could still not find out when this calculation was invented.

Years of business lending experience taught me that the APR was invented by banks to disguise what a loan (whether a business loan, mortgage, car, credit card, etc) actually costs the borrower. The banking industry lobbied hard for APR to be adopted as the national standard, but the government has struggled with how to help make the term clearer for borrowers to understand.

Decoding the APR Financial Mumbo Jumbo

Case in point, the Wikipedia page on APRs has a section titled “APR failings in the United States,” which states (and I quote) – “Despite repeated attempts by regulators to establish usable and consistent standards, APR does not represent the total cost of borrowing in some jurisdictions, nor does it really create a comparable standard across jurisdictions. Nevertheless, it is considered a reasonable starting point for an ad hoc comparison of lenders.”

Want another example of how APR is a misleading metric for evaluating the true cost of a loan? According to Investopedia, “The APR isn’t always an accurate reflection of the total cost of borrowing. In fact, it may understate the actual cost of a loan.” And more, “An APR may not reflect the actual cost of borrowing because lenders have a fair amount of leeway in calculating it, excluding certain fees.”

So, why do we rely so heavily on APRs to compare the cost of loans, especially when the lenders themselves can easily manipulate the rates? It’s because most people don’t know any better. It’s also what we have been taught to do by the banks.

Understanding How APR Mess Hurts Your Business

Now, let’s talk about the shock everyone is feeling because of rising interest rates. The truth is that since the financial meltdown of 2008, we have been in a self-imposed, low-rate environment. But those rates were always going to be economically unsustainable. However, businesses all got used to the low rates, then Covid hit just as they started climbing back up to the “long-term” average or mean. As a result, the rates went down again.

So, how do the recent rate fluctuations impact small businesses? The reality is that 20% of new businesses fail within the first two years, 45% during the first five years, and 65% don’t last 10 years, according to the U.S. Bureau of Labor Statistics. Only 25% of businesses will reach the 15-year mark or beyond.

Therefore, only 25% of businesses have been around long enough to see higher loan rates. The average borrower, the largest cohort being millennials, were kids or teens when the last financial crisis hit and have never faced such rate increases. Until now, they had been living in an artificial low-rate environment. Of course, those borrowers are experiencing a financial shock!

For demonstration purposes, let’s continue using mortgage rates as they are what seem to be most in focus recently. But don’t make the mistake of assuming mortgage rates function differently and are somehow disassociated from normal interest rate dynamics.

In 1971, the mortgage rate was about 8% APR. By 1981, it had jumped to over 18% APR and didn’t come back down to 8% APR until 1993. In 2000, the dot-com bubble burst, which caused a major economic crisis. The crisis led the Fed to start lowering rates to help spur economic growth.

Rates held steadily in the 6% APR range until 2007 when the housing bubble burst, which led to another round of rate reductions to further jumpstart economic activity. By 2017, the economy had recovered enough so that rates started rising again. Rates stayed just under 5.5% until 2020 and then all hell broke loose when Covid hit.

Why the Market Beast Cannot be Tamed

For years, the government has used interest rates to unsustainably manipulate economic growth. Fed officials or others, i.e. Wall Street, had figured out a new way to lead us all down the path to financial disaster — and we all fell for it. Now, borrowers are dealing with higher rates again. But if you do a little digging into the reason for the latest meltdown, you will understand that markets always revert to the mean no matter what the Fed does.

Markets are cyclical, and they can only be manipulated for a limited time. You can only push so much in one direction before you have to switch course to start pushing from the other. That’s the reason why we have rate hike cycles. These cycles are called “QE” or “quantitative easing” and “QT” or “quantitative tightening,” which is where we are now.

Current interest rates have risen back to the mean, where they should be based on market conditions, and would have been without the Fed rate manipulation. We are back to the 1971 rate levels. Since 1971, the average APR has been 7.76% and we are getting close to that level again. But the Fed is pushing too hard and will keep doing so until something breaks, at which point we will begin to push back the other way to find the right balance.

The True Cost of Borrowing: Calculating the Money Factor

A “money factor” is the most direct way of understanding the actual cost of your loan. The factor is displayed as a 1.20 with the 1 being the principal amount borrowed and the .20 being the additional sum repaid along with the principal. This equation creates a total cost of capital of 20% or 20 cents in interest for every dollar borrowed over the life of the loan.

To put this into perspective, borrowing $100,000 would mean you have to pay back a total of $120,000. In order to get the true cost of capital on a mortgage, you’d need to have an APR of 1.6% on your mortgage rate over 30 years. But that equation would only work if the interest on the mortgage was spread out evenly over the 30-year loan period. Mortgage interests are front-loaded, which is why a majority of your monthly payment goes to pay interest.

At 6% APR, your $100,000 mortgage is actually going to cost you $215,838 and the majority of that sum will be paid within the first 10 years. So, the true cost of borrowing comes to 115% total interest paid before including any fees. In other words, you’ll have a money factor of 2.15 or twice the amount borrowed plus an additional 15% interest tossed in for “fun.”

Business Owners Have a Simple Choice to Make

Borrowing isn’t cheap, it never has been and never will be. But capital is an essential part of growing a business. Your business is either growing or it’s dying as I’ve mentioned many times.

You have the option of taking on investors (if any are available) who then become part owners of your company or borrowing the money you need to grow. Wouldn’t it be much more transparent, easier, and safer to know the exact cost of the loan instead of being fed incorrect and inconsistent numbers created simply for the purpose of confusing you?

At First Union Lending, we believe education is the key to business success. Sure, the big banks might even threaten us because of the facts we provide our clients. But it doesn’t matter to me what the banks think.

I only care about making sure you have fair, easy, and fast access to the capital your business needs. Give us a call at 863-825-5626 or visit to start your journey to financial success.

I’m Dennis, senior underwriter at First Union Lending, and I’m here to help.

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