Entrepreneur Magazine

February, 2005

When assessing commercial loan costs,
the interest rate is often only a drop in the bucket.

By Crystal Detamore-Rodman
Writer, Covering Small Businesses

After racking up nearly $900,000 on a revolving line of credit to acquire other businesses for his $9 million commercial and industrial fire-protection company, John Lawlor felt burdened by mounting interest costs--the result of using a financing instrument better suited for short-range capital needs. "When everything slowed down because of 9/11 and other impacts to the economy, those acquisitions were not paying for themselves as robustly [as anticipated]," recalls Lawlor, president of Keystone Protection Industries in Montgomeryville, Pennsylvania.

The solution was obvious: Refinance to rein in runaway interest costs. So Lawlor secured a less expensive form of financing--a fixed-rate term loan--for two-thirds of his outstanding debt, and a new line of credit for the rest. "It wasn't additional money being requested," he explains. "It was the same figure that had been approved years before."

Even so, his bank charged a $5,000 origination fee for the term loan and another $2,500 to establish the credit line. "That's $7,500 just for the privilege of having the bank restructure the loan," stresses Lawlor, 40. "There's a presumed savings in interest expenses each month. But now that you have to offset that with the $7,500 [fee] the bank picks up on the origination of the recasted loan, did I really save anything?"

Sticker Shock
As Lawlor's recent financing experience illustrates, even seasoned borrowers are often caught off guard by higher-than-expected loan costs. While it is common for commercial lenders to tack on extra fees for such things as preparing loan documents, those costs are frequently only the tip of the iceberg. Indeed, lenders charge points, or prepaid interest (often called origination or commitment fees), for holding the credit available, and in some instances, ongoing service fees.

What's more, if the lender requires additional documentation, such as appraisals and environmental reports, or if an attorney is required to close the loan, the borrower picks up those costs as well. As a result, it's possible for a particularly complicated real estate transaction to boost loan costs by thousands of dollars. "If we're doing an environmental assessment, and [it] comes back that there has been potential of a past environmental problem on the property, both the timeline and the cost are just open-ended," says William Galloway, senior vice president of Hibernia National Bank in Metairie, Louisiana. Though the typical appraisal costs $1,000 to $2,000, "I've seen them run as low as $300 to as high as $17,000," he reveals.

Borrowers, however, can guard against escalating loan costs by asking their lenders to cap both legal fees and the amount paid for any third-party reports, such as the sometimes pricey environmental review. "It protects you from surprises down the road, when all of a sudden the deal becomes more complicated because there's a title issue or a survey issue, and it pumps the lender's counsel fees way up," says Peter Smith, an attorney at Semanoff, Ormsby, Greenberg & Torchia LLC in Jenkintown, Pennsylvania. He says in some cases, lenders can acquire discounted rates from third-party professionals because of the large volume of business they conduct with them. Because third-party fees vary based on the deal's complexity, an attorney or another advisor can help determine the appropriate fee cap for your particular transaction. In general, lenders are often responsive to these sorts of requests, according to Smith.

Timing Is Everything
A successful fee negotiation, however, hinges largely on its timing. Not surprisingly, you lose leverage by prematurely signing the commitment letter outlining the lender's terms and conditions. But bear in mind that a borrower coming from a position of financial strength has more bargaining power than one struggling for fiscal footing. In Lawlor's case, only his longtime banker would give serious consideration to his credit request, which greatly diminished his ability to negotiate. "We were not the sweethearts of all the other bankers," says Lawlor, who met with several lenders to gauge his credit prospects. Most said his company, which had experienced "two very flat years," needed to boost profits before they would extend funds. "One guy was even candid enough to say, 'We would be getting rid of customers with this kind of profile,'" Lawlor remembers. As for his bank, "they probably knew there weren't going to be 10 other banks that were going to scoop me away."

But if you are in a position to deal, you can negotiate a number of things at the commitment-letter stage, from eliminating the often costly "opinion of counsel" conducted by the lender's attorney, to getting rid of the commitment fee altogether, says attorney Charles Ormsby Jr., who's also Smith's colleague. Even if the creditor refuses to waive the commitment charge, it might not collect the fee until closing, which is beneficial from a cash-flow standpoint.

Although it's true that some banks--Hibernia National Bank among them--may eliminate the commitment fee, borrowers usually pay a higher interest rate in return. "We have options where there are no points paid to the bank," Galloway confirms, "but we'll increase the interest rate to offset that." However, the ability to save money upfront--a commitment fee of just 1 percent would run $2,500 on a $250,000 loan, for instance--often appeals to firms that don't plan to keep a commercial property for long and aren't opposed to paying a higher interest rate in the short term.

On the whole, borrowers are in a far better position to make those kinds of determinations when they have all the facts about pricing. To that end, Lawlor urges entrepreneurs to ask lenders to give a comprehensive breakdown of all potential financing costs. Based on that information, they can then decide whether the financing plan is economically feasible.

Read the Fine Print
Along with quizzing creditors about potential charges, pay careful attention to the lender's deadlines, especially cutoff dates for accepting the offer and closing the loan. Missing a critical deadline will not only delay access to financing, but also drive up the interest rate in some instances. "When you're in an increasing interest rate environment like we are, the bank might be happy to let some of the deadlines go," Ormsby says. "Then they can re-quote the rate."

Failure to lock in an interest rate is just one oversight that can inflate financing costs. Another is not carefully examining the lender's financial reporting requirements. "Banks will put in the documentation that they expect audited financial statements, but most small to midsize companies aren't getting audited financial statements," Ormsby says. "You need to review the documents to make sure you're not getting sucked into a requirement for an audit."

Some borrowers disregard that particular reporting requirement because it's expensive and they don't believe it will affect their loan status, when in reality, their creditor may withdraw financing in response to the reporting lapse. Says Ormsby, "All of a sudden, you have a bank loan that you're going to default on because you're not going to hire somebody to do audited financial statements."

Costly Surprises
In the fast-paced entrepreneurial world, time is money. And one of the costliest setbacks is a delay in funding. Often, though, borrowers have only themselves to blame for financing holdups.

"I can't tell you how many times a borrower has come in and has not been filing the proper paperwork with the secretary of state's office in the state they're operating [in], and we find out their charter to do business has been revoked," says William Galloway, senior vice president of Hibernia National Bank in Metairie, Louisiana. "Then they've got to go back and file reports with the state to update their good standing." The business's financing request, meanwhile, remains on hold until the owner corrects the administrative oversight.

In other instances, entrepreneurs make unrealistic assumptions about how fast they can get financing. This often occurs when the business owner negotiates a purchase agreement "that has drop-dead dates in terms of financing being approved," Galloway says, perhaps in as little as one month's time. "If it's real estate, there's no way we're going to get an appraisal and environmental [report] back in four weeks."

Business owners can avoid such costly errors by discussing any major purchases with their creditors, accountants and attorneys beforehand. Says Galloway, "On the front end-at minimal to no cost-those three people can frequently keep a borrower clear of land mines."

Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market