Financial terms you need to know before applying for a business loan | Article – HSBC VisionGo
Unlike big corporates, SMEs would need more funds support when it’s time to expand or in times of market volatility. Most business owners will have to resort to business loans in order not to miss out on hiring the right talent or seizing market opportunities. But before you take out a loan with a bank or licensed financial institution, be sure you are clear with some basic financial terms, so you could choose solutions that work best for your business and repayment ability.
To help businesses analyse their needs and position before applying for a loan, this article will help you understand: What are the differences between monthly flat rate and annualised percentage rate? Is it true that the lower the monthly flat rate, the smaller will be the repayment amount? How do I calculate the repayment amount for my loan? Are there any “hidden fees”?
Monthly flat rate
Monthly flat rate is one of the most common concepts used in calculating the fixed monthly interest expense for a loan.
Monthly interest expense = Monthly flat rate x Principal amount
Interest expense for the full loan term = Interest expense per month x Number of instalments
Total repayment = Interest expense for the full loan term + Principal amount
Monthly repayment = Total repayment / Number of instalments
In general, loans with a definite term will be charged interest on the reducing principal. This means interest will represent a bigger portion of the repayment amount at the beginning of the loan term. But as the outstanding principal reduces, interest will become a smaller part of the repayment. The monthly flat rate is used to make it easier for borrowers to calculate interest expense and repayment amount.
The idea is to “evenly distribute” all interest expenses throughout the loan term, to see how much interest is payable every month, with the assumption that the borrower will repay a fixed amount of principal and interest every month. Therefore, the monthly flat rate does not reflect the actual costs to the borrower. Rather, they should refer to the annualised percentage rate (APR) to understand the real costs involved.
Annualised percentage rate (APR)
The annualised percentage rate is an index of borrowing cost reflecting actual outgoings per year, including interest and all related fees/charges, such as handling fee, administration fee, etc.
Calculations for the APR is more complicated, but we may still have an approximate figure for reference, using a simple formula of the monthly flat rate where:
Annualised percentage rate (APR) = monthly flat rate x 12 months x 1.9 (constant coefficient)
Some loan products claim they charge “monthly flat rate as low as 0.0x%” without giving details of the handling fees. Now if two loan products, A and B, both offer the same monthly flat rate, but Product A has a higher APR than Product B. This may mean Product B charges a lower handling fee, or even waives it altogether. Hence, borrowers should always refer to the APR when comparing different financial products.
Borrowers are entitled to ask the institution for APR information during their loan application, so that they can compare between products better.
What does a monthly rate of 0.2 % mean? How much is it when translated into APR?
In Hong Kong, one-hundredth is also called as “Li”. For instance, a monthly rate of 0.2 “Li" means the interest to be charged will be 0.2% on the principal amount each month, or 0.2% x 12 x 1.9 = 4.56%, or 4.56 “Li” on the principal amount.
Prime rate (P)
Prime rate (P) is the basic lending rate offered by banks to their most valued and credit-worthy customers. Other customers will generally be offered loans at P plus a premium. Each bank is at liberty to fix its own P rate. For example, HSBC currently offers P at 5.0% since 1 Nov 2019, while DBS has set P at 5.250% since 4 Nov 2019 .
On the back of the government’s SME Financing Guarantee Scheme (SFGS), local banks are offering even lower loan rates to further take repayment pressure off SMEs. For example, HSBC is currently offering SME loans at current P (5.0%)-2.25%, bringing APRs at 2.75%.
How do I calculate the total repayment amount?
Assuming Company A applies with Bank B for a HKD1 million SME unsecured loan for a term of three years. Bank B only said it is offering the loan on “monthly flat rate as low as 0.25%”. In reality, the APR will be:
0.25% (monthly flat rate) x 12 months (one year) x 1.9 (constant coefficient) = 5.7%
However, it should be noted that this is a rough estimate only. You should check out the more accurate figures by using online tools from the relevant banks to convert the monthly flat rate into APR. When you key in the monthly flat rate of 0.25% on your bank’s APR calculator, it will show that the APR is 5.81%. With this APR, you can find out what you will have paid in total repayments, using the following formula:
$1,000,000 (principal) x 5.81%(APR) = $58,100 (actual interest paid per year)
x 3 (years) = $174,300 (total interest paid over three years)
+ $1,000,000 = $1,174,300 (total repayments made)
It is most important for business owners to know their exact total repayments, so that they know what to do in arranging for their repayment plan.
Terminology relating to repayment method
Straight-line method, or average capital plus interest method/fixed instalment method:
Refers to repayment of both principal and interest at equal amounts and hence the repayment amount will be the same each month. In Hong Kong, most loan products are offered on the basis of this repayment method, where interest payments take up the highest proportion of the monthly instalment at the beginning of the term, and gradually reduce to lower proportions towards end the term. This is suitable for borrowers who do not wish to come under too much pressure for repayments at an early stage.
Illustration of calculation:
A customer borrows HK$120,000 for 12 months, at a monthly flat rate of 0.14% and handling fee is waived. The loan principal is HK$120,000.
Monthly interest expense = Total principal amount x Monthly flat rate = HK$120,000 x 0.14% = HK$168
Total interest expense for the full term = Monthly interest x Number of instalments = HK$168 x 12 months = HK$2,016
Monthly repayment = (Total principal amount+ Total interest for the full term)/Number of instalments = HK$(120,000 + 2,016) ÷ 12 = HK$10,168
Reducing balance method, or average capital method
Refers to repayment of principal at fixed amounts each month throughout the term, with interest payment decreasing in line with the principal. Hence the instalment amount would vary and reduce with each month. This is suitable for borrowers with better repayment ability at the early stages of the term. However, use of this method will be subject to negotiation between the lender and borrower.
The monthly instalment amount is determined by distributing the principal amount equally over the actual number of months in the term, plus an amount of interest to be charged on the outstanding principal since the last repayment. Therefore, repayment amounts under reducing balance method tend to be higher at the beginning, but will continue to reduce each month as the outstanding principal diminishes.
What other costs are involved in borrowing money? Common extra costs include:
- Annual Fee/Service Fee
Some loans have a fee (usually annual) for maintaining the loan account
- Handling Fee
The bank may charge a fee for processing the loan application, which is usually a one-time payment at the beginning of the repayment period.
- Early Redemption Penalty
In some cases, if you wish to fully repay a fixed loan earlier than the agreed term, you will have to pay an extra fee to compensate for the interest lost by the bank.
- Late Repayment Charge
If you fall behind on your loan repayments, you will be charged interest on the overdue amount on a daily basis, either at a fixed rate or at the prevailing rate, and/or a fee. Therefore, you are encouraged to budget accurately and keep up the repayments.
- Unauthorised Overdraft Handling Charge
If you exceed your overdraft limit originally assigned to the account, you will have to pay an extra fee to the bank.
Tips: To borrow or not to borrow? Borrow only if you can repay!