Your overdraft is not costing you 8%

Every working capital facility is quoted as a rate. The rate is on the term sheet, it is the number the broker leads with, and it is the number you will compare against the next offer. It is also, on most of these products, nowhere near what the money costs you.

This is not a scandal and nothing is hidden. Every fee is disclosed. It is just that nobody adds them up for you, and the arithmetic that turns a quote into a price takes about two minutes once you know which two numbers to divide.

The whole calculation

Take everything the facility costs in a year: interest, every recurring fee, and the establishment fee spread across how long you will actually keep it. Divide that by the money you genuinely had the use of. That is the effective rate, and it is the only figure that lets you compare one facility against another.

The denominator is where facilities are made to look cheap. Divide the same cost by the approved limit instead of the balance you actually drew, and an overdraft costing 10.4% presents as 4.9%. Nothing about the facility changed. You just measured it against money you never borrowed.

An overdraft, worked through

A $250,000 limit quoted at 8%, with a line fee of 1.5% on the undrawn portion and a $2,500 establishment fee. Across the year the business draws an average of about $117,000, which is a fairly typical pattern: heavy at the quiet end of the season, light at the busy one.

The line fee is the part that surprises people. It is charged on the headroom you are not using, which means a generous limit you rarely touch is not free optionality. It has a price, and here it is a fifth of the total cost.

Invoice finance, where the gap gets serious

Invoice finance advances you a share of your invoices as you raise them. The interest looks similar to an overdraft. The difference is what the service fee is charged on.

Consider $200,000 of invoices a month, 85% advanced, customers paying at 45 days, quoted at 8% with a 1.2% service fee. You receive $170,000. The service fee is charged on the full $200,000.

That single convention, a fee on the gross invoice against an advance of only part of it, is most of the difference between eight per cent and thirty-one. It is disclosed in every term sheet in the market. It is almost never added up.

This does not make it a bad product

It is worth being clear, because the numbers above look damning and they are not the whole picture. Invoice finance advances far more than an overdraft will against the same business. It scales automatically as you sell more, rather than needing a review every time you grow. And it funds work that an overdraft simply would not cover.

A facility at 31% that lets you take on a contract you could not otherwise service can be the best decision you make in a year. Expensive money that produces something is better than cheap money that is not available. The point is not to avoid the product. The point is to know the number when you decide, rather than to discover it in a year of bank statements.

Three questions worth asking any lender

• What is this charged on? Interest on the drawn balance and a fee on the gross invoice are very different things, and only one of them scales with what you actually receive.
• What does it cost if I only keep it a year? Establishment fees spread over the life you expect. Halve the life and that line doubles.
• What is the effective rate on the funds I will actually draw? A lender who cannot answer that has not worked it out either, which tells you something.

Comparing two offers properly

Once you have the effective rate on both, you are comparing prices rather than marketing. Often the answer flips: the facility with the higher advertised rate and no fees costs less than the one advertised cheaply and loaded with them.

And effective rate is still only one input. What a facility does to your security position, your covenants and your capacity to borrow again all matter, and none of them appear in a rate of any kind.