The cost of borrowing

How is the cost of borrowing decided?

In essence, the cost of borrowing will depend largely on the lender’s own ‘cost of funds’, as well as the perceived risk of lending money to the borrower. This perception may be influenced by four factors in particular: Amount, term, security and risk profile. You may not agree with them, but lenders may adopt some of the following views:

Amount: Generally speaking, the lower the amount, the higher the interest rate and the higher the percentage fee.Why? Cost of setting up the loan has to be recouped from a smaller and often shorter lend. Also the need to borrow, rather than already having a relatively small amount of cash, can be seen as a possible warning sign and therefore high risk.

Term: High Street funders tend to reduce the interest margin, the shorter the term, this is because they are tying up their funds for less time. However, alternative lenders who specialise in short-term lending, may well charge higher rates. Why? As with small amounts, they still need to recoup the cost of arranging the loan, cover risk and make a profit and they have less time to do this.

Security: Usually the better the legal security cover the lender has, the lower the interest rate will be. Why? Because the security gives the lender a further option if the loan is defaulted on, and therefore reduces risk.

Risk Profile: This refers to your track record, either as an existing customer of the potential lender, or as a customer of other bodies, so primarily what is your credit score and credit history like? The worse this is, the fewer the number of lenders prepared to take a risk and the higher the cost of borrowing. Why? A poor credit history is an indicator that you don’t regularly meet your obligations, so more work for the lender and more risk. Similarly, a business continuously making losses is likely to run out of cash and options at some stage, so again more risk. And higher risk leads to higher cost of borrowing.

OK, I understand those things now, but what can I do about them? In essence, the larger the number of lenders who are willing to deal with you, the wider the choice and this is very likely to lead to lower cost. You therefore need to make yourself as attractive as possible, to as many lenders as you can. How do I do this? Essentially you need to demonstrate that you are a good, or improving risk. To give an example: Do you regularly make late payments to suppliers or finance agreements? Most of this data is visible to anyone assessing your risk profile via credit agency reports such as Experian or Equifax. If your history is poor, you really need to start improving it and you can’t start soon enough, as these improvements will take time to filter through to your profile.

That’s all very well, but I’m not paying on time because I need more funds . . . Sometimes you will have to take a short-term hit for a long-term plan. For example, you may feel that the only finance that you have been offered is “too expensive”, but if this allows you to bring, and keep, your creditors up to date, you can then improve your profile making yourself a more attractive proposition to more lenders and, after say 6 months, refinance to a better rate. In the meantime, if you are struggling to meet your commitments, do make sure that you stay in close touch with your creditors. Perhaps try to negotiate lower interim payments, but most of all keep them from taking any precipitative action such as registering CCJs, which will have a significant effect on your profile.

Are there any other things that I can improve? Yes, if you are trading as a limited company and you are late filing your accounts at Companies House, this will have an impact, so get it sorted as soon as possible. Make sure that you provide your accountant with all the information they need – get those accounts registered quickly each year. Also consider security: do you have any assets that you are prepared to offer as security behind your borrowing? If borrowing via a limited company, agreeing to give a personal guarantee will help significantly with the number of lenders prepared to consider lending to you.

You also mentioned filing accounts – I haven’t done this because they are not very good If your accounts are more than 9 months late, then you’re probably incurring fines by now, which is only going to make your finances worse. Moreover, most lenders can cope with “bad news” better than “no news” and, as prospective new lenders, will want to see up-to-date information before agreeing to lend you money. Also, if you haven’t got the information – or say that you haven’t got the information - that casts doubts on your overall abilities and makes you a higher risk. Less attractive, less options equals more expensive . . .

I guess, shopping around for the best deal is a given Yes, but avoid multiple applications. Multiple credit searches will be visible on your history and will have an impact on your credit rating. Will potential lenders see it as “shopping around” or more worryingly declined or desperate. If so, your funding costs may increase. To avoid multiple credit searches, don’t make multiple formal applications and check with lenders at what stage they carry out “hard” credit searches. Alternatively use our Funder Finder, where “soft” searches will be carried out and we will provide you with a short list of potential funders without leaving a credit search footprint. Finally, remember to read the small print: For example, is there an additional cost to repaying early? Are there any ancillary fees? What happens if you are late with a payment? All worth checking out before you sign on the dotted line.