The cost of finances (COF) is the cost, interest, and other charges associated with borrowing money to build or purchase assets or to fund your business.
The following are the three common costs of financing:
1. Collateral
2. Interest
3. Equity
Collateral
This can also be referred to as security, surety, or a guarantee. It is a valuable asset that is pledged as security for loan repayment and is forfeited in the event of a default. It serves as a safety net for the lender in the event that the business owner is unable to repay the loan.
Most lenders will require some sort of collateral before they issue a loan. There are different types of collateral including:
- Property (e.g. an owner’s home)
- Business’s inventory
- Cash savings
- Investments
- Equipment
Long-term loans usually necessitate the use of collateral. Once the borrower has paid off the loan, the asset is no longer collateral, and the lender no longer has any rights to it.
It is highly unlikely that collateral would be required for a short-term loan. Unsecured loans are those that do not require collateral. This is advantageous for businesses that do not have any assets, property, or someone willing to sign a surety on their behalf.
If you do not make the payment, you may still be held personally liable, and your assets may be sold. The disadvantage of an unsecured loan is that the interest rate is usually much higher than that of a secured loan.
Marketable collateral
The exchange of financial assets such as stocks and bonds for a loan between a financial institution and a borrower is referred to as marketable collateral. Assets must be able to be sold under normal market conditions and with reasonable promptness at current fair market value in order to be considered marketable collateral. Transactions in an auction or similarly available bid or ask price market are used to determine the conditions. To accept a borrower’s loan proposal, national banks require collateral that is equal to or greater than the loan or credit extension amount.
The total outstanding loans and credit extensions to a single borrower may not exceed 15% of the bank’s capital and surplus, plus an additional 10% of the bank’s capital and surplus.
When securing loans with marketable collateral, the main risk is collateral value reduction. Financial institutions closely monitor the market value of any financial asset held as collateral and take appropriate action if it falls below the predetermined maximum loantovalue ratio. A loan agreement or margin agreement will usually specify the permitted actions.
Valuing your Assets
In most cases, the lender will make you an offer that is less than the value of the asset you have pledged. Some assets may be significantly discounted. A lender, for example, may only recognize half of your investment portfolio as collateral for a loan. In this manner, they increase their chances of recovering their entire investment capital if the investments lose value.
Types of Loans
Collateral loans can be found in a variety of places. They are commonly used for both business and personal loans. Because they lack a long track record of profitability, many new businesses are required to pledge collateral (including personal items that belong to business owners).
In some cases, you can get a loan, buy something, and then pledge it as collateral all at once. In premium financed life insurance cases, for example, the lender and insurer frequently collaborate to provide both the policy and the collateral loan at the same time. A financed home purchase is similar in that the house secures the loan, and if you do not repay, the lender can foreclose on the home.
There are some collateral loans available for people with poor credit. These loans are frequently costly and should be used only as a last resort. They are known by a variety of names, such as car title loans, and generally entail using your vehicle as collateral. Be cautious with these loans: if you fail to repay, your lender has the right to repossess and sell your vehicle, often without informing you.
Borrowing Without Collateral
If you don’t want to put up collateral, you’ll need to find a lender who will lend you money based on your signature (or the signature of someone else). Among the alternatives are:
Personal loans and credit cards are examples of unsecured loans. Online loans (including peer-to-peer loans) are frequently unsecured loans with low interest rates.
Obtaining a cosigner to apply for the loan with you, thereby jeopardizing their credit. Borrowing without using anything as collateral is probably not possible in some cases, such as when purchasing a home (unless you have significant equity in the home). In other cases, borrowing without collateral may be an option, but you will have fewer options and will have to pay a higher interest rate.
Interest and Interest Rates
Debt financing has a cost. Interest is the fee charged when someone lends you money. The fee is the cost of being able to spend in the present rather than having to wait until the future. The interest rate is calculated as a percentage of the amount borrowed.
How are interest rates determined?
The central bank of the country in which you live determines interest rates. The prime lending rate is the lowest rate at which a bank will lend to its customers.
Your risk profile, the size or amount of the loan, inflation, and the term of the loan are all factors that influence your interest rate on a loan.
How Interest Works
You must enter into a “interest agreement” with the lender before obtaining a loan from a bank, credit union, or other lender. You agree to repay the following through these agreements:
the principal balance — the original amount borrowed the interest — a fee you pay the lender in exchange for borrowing money from the lender The interest rate is calculated as a percentage of the amount borrowed per year.
For example, if you borrow $100 at 6.8 percent interest, your loan interest will be $6.80 at the end of the year.
In this case, your daily interest is estimated to be around 2 cents ($6.80 divided by 365 days in a year).
Cost of Equity Finance
The term “equity” refers to a person’s ownership or the number of shares in a company. Equity capital, also known as retained equity on the balance sheet, refers to the money that owners have invested or profits that have been retained in the business.
The cost of obtaining equity finance is the ‘loss of ownership,’ as you would be selling a portion of your business to someone else.
You must first determine the value of your business in order to calculate the number of shares you will sell for a specific price. Equity investors will almost certainly value your company using their own team.
As a result, it is critical that you both evaluate your business in a similar manner.
When considering equity financing, don’t think of having to sell your company’s stock as a loss; instead, think of it as your company gaining additional value, allowing it to meet its future growth goals.
