Finance and money can sometimes be trickier than you think. Whether you’re financing a car purchase, opening a credit card, or taking a mortgage out, it pays to read the details.

The world of business loans is no different. There are a myriad of options with different rates, cost structures, and clauses. In the world of high growth SaaS, there is a lack of mainstream banks willing to provide debt, which has led to private capital coming in to fill this gap. We at Element are one of these companies “filling the gap.”

Recently, we were approached by a founder trying to procure non-dilutive, growth financing for his SaaS company. He found our website while searching for an interest rate calculating tool on Google. When he reached out to us he was looking for help understanding the calculator.

“How could this 20% rate not be 20%?” he asked. Yet, he knew something was amiss. While this may sound crazy, the 20% “interest rate” he was offered was not an interest rate as he understood but a flat rate of 20% (the equivalent of a 35% interest rate on an amortized loan).

This conversation wasn’t unusual for us. We often have conversations with founders regarding the cost of finance, how to compare it, and why many lenders’ rates are actually more expensive than they appear.

##### Let me explain.

Most people are familiar with loans using interest rates and balances that amortize, just like most mortgages. That is, a portion of the principal is paid down with each payment, and subsequently, the amount of interest paid each month lowers over time.

Many of these SaaS lenders with the self-proclaimed “low rates” of 12%-20% are offering them on loans without amortization. I.e. their loan repayment amount is 112%-120% of the amount borrowed and repaid in equal monthly payments over 12 months.

$100,000 + $20,000 (20%) = $120,000

$120,000 / 12 = $10,000 monthly payments

Simply put, a flat rate of 20% costs more to repay than 20% interest with amortization. So how exactly was the gentleman I mentioned earlier offered essentially 35% interest?

##### Let’s look at a loan with amortization.

The monthly payment on a 20% interest loan with amortization is $9,263.45. Now, let’s compare this loan against the 20% flat rate loan the company was offered.

As you can see in the example above, both loans have the same stated percentage rate but have two different payment amounts and total cost of finance. This is because the first loan’s principal is being reduced every month through amortization.

By digging deeper, we can use the total cost of finance of the flat rate loan to find the equivalent interest rate that results in the same payment amount and cost of finance. The flat rate loan’s cost of finance was $20,000, so we’ll look for an interest rate that results in the same cost. In this case it is 35.075%.

Clearly, paying $20,000 (a 20% fee) in interest on a one-year loan of $100,000 is substantially more expensive than a 20% interest rate with amortization. So much so, that an equivalent cost of finance with amortization is 35.075%.

##### Let’s compare all three loans:

$20,000 – $11,161.41 = $8,838.59 of potential savings. That makes the 20% fee the founder was offered 79% more expensive than it looked.

In my opinion, this practice is aggressive lending at best and intentionally deceptive at worst. I’ve even seen companies advertising 6% fees over 6 months, which becomes an annual 12% fee and the equivalent of a 21.458% interest rate with amortization. Founders need to be wary of companies offering such deceptive finance costs.

At Element, we recommend every SaaS company compare the total cost of finance between term sheets. If you get offered an interest rate that is actually a flat fee, you can compare it against loans with amortization using our interest rate calculator.