Example 11 – Ordinary One Year Loan: A company borrows $ 100,000 with a loan maturity of one year. The stated interest rate is 12%. The effective rate or annual financing cost is $ 12,000 or $ 100,000 x 12%. There is no difference between the stated and effective rate.
Loans with a maturity less than one year will have a higher effective rate or financing costs since the interest is paid back in less than one-year. The formula for calculating the annual financing cost (AFC) is:
AFC = ((Interest + Fees) / Usable Funds) x (360 days / Loan Maturity in Days)
For purposes of making the calculation a little easier, we will use 360 days for one year.
Example 12 – Ordinary Bank Loan: A company borrows $ 100,000 with a loan maturity of 90 days. The interest rate on the loan is 12%.
AFC = 12% x (360 / 90) = 48%
Example 13 – Discounted Bank Loan: A company borrows $ 100,000 with a loan maturity of 90 days. The interest rate is 12%. The bank requires interest be paid in advance. Proceeds received are $ 88,000. This represents the “usable funds” available from the loan.
AFC = ($ 12,000 / $ 88,000) x (360 / 90) = 13.64% x 4 = 54.56%
Interest is not always the single cost of financing. You may incur other fees. These fees should also be included in your calculation of annual financing costs.
Example 14 – Six Month Loan with Fees: A company will borrow $ 100,000 to be paid back in 6 months at 16% interest. The loan includes several fees totaling $ 1,000. What is the annual financing cost of this loan?
Interest Cost ($ 100,000 x 16%) . . $ 16,000
Processing Fees . . . . . . . . . . . . . . . $ 1,000
Total Financing Costs – 6 months . $ 17,000
Financing Rate – 6 months . . . . . . . . . . 17% ($ 17,000 / $ 100,000)
Annualized Basis (360 / 180). . . . . . . . 2.0
Annual Financing Cost Rate . . . . . . . . 34.0%