Finance 101 - 11.9.2016

Explaining Interest Rates

Our underwriting team put together a little primer in order to help you make the best decision

Interest rates. APR vs APY. High rates vs low rates. When you're out looking for credit, these terms are very important to understand. Below is a little primer put together from our underwriting team in order to help you make the best decision.

Ok, so what is an interest rate?

An interest rate is the amount you pay on the credit you have received. If you take out $100 of credit with a 5% interest rate, you will pay back $105 in the agreed amount of time.

And APR vs APY?

APR stands for “Annual Percentage Rate” and APY means “Annual Percentage Yield.” APY takes into account compounding effects of interest while APR does not. APY however doesn’t affect Able borrowers because interest is paid off on a monthly basis, so there is no compounding effect.

Anything I need to know about the difference between interest rate and APR?

Yup. A huge one: APR is inclusive of fees. Origination fees for example should be included in the APR. So in one sense, as a borrower you should be most concerned with the APR as that is the real dollar amount you will be paying. You could get a great deal on an interest rate (”wow! 5%”), but if you are paying a 5% origination fee your APR will be much higher than the interest rate advertised.

Ok, let’s get nerdy. How does Able set rates?

Now, that is a huge question. First we run a credit model (this is done by our savvy data scientist Glen). From that credit model we produce a base rate. Specifically, we use statistics and machine learning algorithms trained on historical data to determine:

  • The likelihood of default and
  • The estimated default time (in the event that the loan were to default).

From the second bullet above we can then determine the estimated loss severity (or loss given default). From there, we can determine estimated losses.

We also adjust the rate to cover the estimated loss of each borrower and the cost of our own money, such that for each borrower we are not doing the deal at a loss.

Then we analyze the borrower’s financial statements, bank statements, projections, and purchase orders. We use this information to determine the health of the business and its creditworthiness. We may elect to offer a loan at the base rate, adjust the rate, or decline to offer a loan.

What sorts of metrics do you use to determine the financial health of my company?

Determining financial health is both art and science. But we look at the same sorts of metrics as a bank or the SBA.

Here's a short list of some of the metrics we use, as well as what looks "good." This is a great list to apply to your own business to gauge your overall financial health as well.

The amount of top-line gross revenue that the company produced over the previous 12 months. Our minimum amount is $100,000.

Gross profit (revenue minus cost of goods sold) as a percentage of revenue. Preferably above 40% but lower margins may be acceptable based on the company’s industry.

All expenses incurred over the past 12 months subtracted from revenue over the last 12 months. Preferably greater than zero.

Current assets divided by current liabilities. This demonstrates the company’s ability to pay off its liabilities that come due over the next year. Preferably greater than 1.

Cash plus account receivable divided by current liabilities. This demonstrates the company’s ability to pay off its liabilities that come due over the next year if it is unable to sell its inventory. Preferably greater than 1.

Total liabilities divided by total assets. This demonstrates the company’s ability to pay off all of its debt with its assets. Preferably less than 60%.

Net operating income divided by total principal and interest payments on debt obligations over the next year. This demonstrates the company’s ability to pay off its debt obligations in the coming year. Preferably greater than 1.

Are you on it. Do you have likes, followers, and activity. This isn’t a huge one, but we do look to see how engaged with your community you are.

So is it all just going into a magic Excel doc and a robot is determining my creditworthy fate?

Not at all. These are just tools that we use to holistically assess the health of a business.

A really important thing to remember is that having Backers, two to five people who you recruit to fund 10% of your loan, tells us a lot about you and your business. This is not a touchy-feely marketing ploy, but it is a huge part of our decision-making process. Things done in community (people who know and care about your business) are healthier than things done by robots. Our models work for us; we are not slaves to them.

Thinking about applying for a loan, or have questions about our funding process? See how much you qualify for here (without affecting your credit). We want to help.

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