Did you know that as soon as a business transitions from borrowing as a sole trader (where lending is covered by the Consumer Credit Act) to raising debt finance as a Limited company, business owners are no longer protected by regulation? This means that simple protections, such as the requirement for finance products to carry an Annual Percentage Rate (APR), no longer apply.
For example, if a business owner took out a mortgage against her house, the finance provider would be required to disclose the APR. If the same business owner raised the same amount of finance for her Limited company however, the provider would be under no such obligation to do so.
The lack of APR in commercial finance has led to the supply of complex commercial finance products to small and medium-sized enterprises (SMEs), with a range of tariffs and charges that ultimately, and arguably deliberately, hide the true cost of finance. This means that SMEs often end up paying more than they expect.
In the absence of an APR, business owners should carefully consider the cost of commercial finance. The best way to do this in our opinion is to calculate everything you will pay, including interest and fees, relative to the amount you will borrow, on average, over the course of one year.
Growth Street has therefore built a calculator that estimates the cost of commercial finance across a range of popular providers and products. It fully discloses the assumptions and calculations necessary to derive an approximate APR, as well as the total cost of credit (TCC), to help business compare costs.
Academic research from the USA regarding reform of the Truth in Lending Act (TILA), which mandates APR, shows why it’s important to calculate finance costs over a year, rather than rely on other metrics, such as the monthly repayment amount:
“When an interest rate is not disclosed, most consumers substantially underestimate it using information from the monthly repayment, loan principal and maturity. This ‘fuzzy math’ or ‘payment/interest bias’ helps explain why lenders shroud rates… even under the threat of fines and litigation… The results link a cognitive bias to firm strategy and market outcomes, show that mandated disclosure can attenuate those links, and highlight the importance of enforcement costs.”
We believe that by making APR mandatory in the UK, SMEs will be able to more easily access and select finance on more competitive terms, by making informed choices between products and providers, supported by transparent price information. The authors of the USA TILA study suggested that the cognitive bias they identify may be responsible for users paying as much as a 4% more than they first anticipated. The figure may be even higher in the UK SME market. Attenuation of this bias, which will increase competitiveness and productivity, would be a significant boost to growth and employment.
By James Sherwin-Smith, CEO, Growth Street