Feature image for Interest Rates, Caps, and Discount Rates: Are You Struggling to Tell the Difference?

Interest Rates, Caps, and Discount Rates: Are You Struggling to Tell the Difference?

If you’re a Founder looking for startup financing, there’s a few questions that might pop into your head.

  • How much capital am I getting?
  • How much will it cost?
  • How long will I have to pay it back?

Unfortunately, different lenders use different structures and terms that can make it difficult to compare. Three common terms lenders use are interest rates, caps, and discount rates, all of which can make a big impact on your cost of capital.

So, what are interest rates?

If you’re dealing with simple interest rates, paid back in fixed monthly installments, you can expect a pretty clear roadmap.

Say for example you take out $100,000 with a 12% interest rate, to be paid back over the course of a year.

How much capital are you getting? $100,000. How much are you paying in return? Well, since your interest rate is 12%, you’ll be paying back the initial $100,000 principal plus $6,618.55 in interest.

And since we’re dealing with a fixed payment structure, you’ll have 12 separate $8,884.88 installments, assuming your lender is collecting equal, monthly payments and amortizing over the life of the debt.

Although they can be the cheapest option, there are certain drawbacks to interest rates, commonly associated with your typical bank loan.

Lenders will often require profitability, credit checks, and personal collateral, meaning they’re not always a great fit for SaaS Founders.

Then what’s a payment cap?

Another way you might see your rate expressed is in the form of caps, either as a percentage or a multiplier. Although at first caps may appear similar to regular interest rates, the structure is distinctly different.

Let’s assume we’re once again dealing with a $100,000, one-year loan, and our cap is 12% (or 1.12x). 

Under this structure, you’ll still have access to the full $100,000 at close, but you’ll be paying a total of $12,000 in interest (in other words, 1.12x the principal of $100,000).

Returning to our three big questions:

How much capital am I getting? $100,000. How much will it cost? A total of $112,000. How long will I have to pay it back? You’ll have one year.

But since caps are the maximum rate you’ll be required to pay, depending on the structure, some facilities will reward you for paying back your balance early by pro rating your rate (e.g., the cap is lowered to 1.10x for repayment in six months versus the original 12 months).

And despite the higher cost of capital, many facilities featuring caps – such as the ones offered at Novel – do not require warrants, covenants, or personal risk guarantees, unlike bank loans.

It’s also important to note that although we’re using a one-year term here for the sake of consistency, many providers will offer longer repayment terms for caps, which can end up netting out against interest rates.

To give you an apples-to-apples with regard to interest rates, this equates to a 21% annual percentage rate (APR) if we assume no additional fees beyond the payment cap.

Although it’s much higher than the previous example, you need to weigh your ability to qualify and the personal risks you might have to take with a traditional loan. To put it simply – is the potential to lose your house worth the difference in costs?

Now explain a discount rate. What's the difference?

On the other hand, if you’re dealing with discount rates, the cost is going to be similar to caps, but the amount of capital available up front is different.

Let’s return to the same example: you want $100,000, but this time, you’re dealing with a discount rate of 12%.

Instead of getting $100,000 and paying back an additional 12% over the course of a year, the 12% discount rate is going to be applied up front, leaving you with only $88,000 in capital to deploy.

However, assuming a fixed payment structure, each installment is going to be a bit smaller, because you’re only paying back the principal of $100,000, without any added interest on top.

So, back to our three questions once more.

How much am I getting? $88,000.

How much am I paying in return? Well, since discount rates are applied up front, you’re paying back $100,000 in total, but in return, you’re getting access to less capital up front.

How long will it take me to pay it all back? If you’re offered a fixed payment structure, then it’s the same answer as before, one year.

For comparison purposes, this translates to a 24% APR if we assume no additional fees and stick with the 12-month payback.

In-text graphic for Interest Rates, Caps, and Discount Rates: Are You Struggling to Tell the Difference?

As we’ve learned, that 12% on your facility can look a lot different, depending on the structure. A 12% interest rate, paid back over 12 months, is not the same as a 12% discount rate, paid back in only six months, or a 1.12x cap, paid back in 18 months.

And if you’re feeling overwhelmed, don’t worry. Just return to those three key questions we’ve been discussing all along.

How much am I really getting? How much will it really cost in return? And how long will it really take me to pay it all back?

Once you’re able to answers these questions definitively, then you’re ready to take the next steps and choose the type of financing that’s right for you.

To learn more, visit our Growth Center.

Related Posts

Related Posts