Types of Business Loans
After a small business owner has taken all the necessary steps to begin to establish a positive credit history through vendor lines of credit and small credit cards, applying for other types of business loans becomes a more realistic option. At this point, understanding the different features that can be included in a business loan is very helpful when trying to determine which business loan is the right one for you.
Agreements: Often, the business owner must agree to maintain accurate financial statements and business records, to perform at certain standards based on financial ratios, and keep their tax and insurance payments current.
Collateral: In a business loan, collateral is a security or guarantee (usually of an asset) that is pledged to cover the repayment of the loan if the borrower fails to meet the terms of the loan. Common types of collateral are real estate equity, accounts receivables, and business inventory and/or equipment. The key variables that often determine whether or not collateral is required in a business loan are number of years in business and size of the business. Three years is typically the minimum amount of time a financial institution will require a business to exist before waiving the requirement for collateral. However, when it comes to the size of the business, this criteria can be determined by number of employees and/or amount of revenue generated. Many lenders’ loan programs are designed to target certain sized businesses, so it is very important to do your research when it comes to potential lending institutions.
Covenants: A loan covenant is a condition that a borrower must comply with in order to adhere to the terms of the loan. If a borrower does not meet the covenants, the loan can be considered in default and the lender is given the right to demand payment in full. Lenders typically require covenants in a business loan to maintain loan qualify, keep sufficient cash flow, preserve the equity in a loan, to maintain capital structure in situations where this is a weakness, and to keep an updated portrait of a borrower’s financial performance and conditions. Common business loan covenants include proof of hazard/content insurance, proof of life insurance for the owner or manager without whom the company could not contninue (lender is listed as beneficiary to cover loan amount), current taxes/fees/licenses, submission of updated financial statements of the business (used for continuing assessment by the lender), and minimum financial ratios related to liquidity and profitability and leverage. In addition, the lender may prevent a borrower from doing certain things, including changing management or merging without prior approval, incurring additional debt, and eroding the net worth of a company through dividend payments or stockholder withdrawals (often limited to owners’ tax liability).
Interest Rate: This the specified percentage that will be charged by the lender as payment for use of the funds issued. These rates can vary depending on the length of the loan term, the type of loan they are associated with, the amount of the loan being issued, and the credit rating of the business applying for the loan.
Personal Guarantee: When a lender requires the personal guarantee of the business owner, that means that even though the loan is described as a “business” loan, the borrower’s personal credit history will be used to qualify for the loan, the activity of the business loan will be reported to the personal credit bureaus through the business owner’s Social Security Number (SSN), and the business owner’s personal assets can be seized in the case of non-payment. A personal guarantee is still binding even if the business is corporation that is a separate entity from the borrower.
Promissory Note: This is the document that describes all of the terms of the loan. Often the Loan Agreement and the Promissory Note are combined into one comprehensive document.
Repayment Schedule: The required repayment schedule may dictate monthly, quarterly, or lump sum payments. However, some loan programs allow these payments to be deferred or delayed in order to allow your business to generate cash flow.
Representations: These are statements of fact or declarations made by the lender within the loan document. One example of a business loan representation would be that all liens against the business are disclosed.
Restrictions: The lender may also place additional restrictions on the total debt a business agrees to incur, the amount of dividends or other payments to owners and/or principal investors capital expenditures, the sale of fixed assets.
Secured Loans: Some loan programs may require a compensating balance to be held in a special account as collateral during the life of the loan. These balance requirements can be any amount from a small percentage of the loan amount to the full amount of the loan. When all of the terms of the loan have been met and the loan has been paid in full, the collateral deposit is returned to the borrower.
Term: This is the period of time that covers the life of the loan. There is a wide variety of loan programs that cover all kinds of different loan terms, so make sure that you apply for a loan that meets your immediate and long-term needs.
Warranty: In the case of a business loan, a warranty is an assurance by one party involved in the loan to the other that affirms that certain facts and/or conditions are true at the time of the loan or will happen during the life of the loan. Both the lender and the borrower are obligated to uphold any warranties that are part of the loan and seek some type of remedy if the warranty is not true or followed.
Once a borrower understands all the features that can be included in a business loan, the next step is to research the various types of business loans that are available in order to determine the best loan program for your needs.
Collateralized Loans: It is very common for a loan program that is designed for small businesses to require collateral in order to secure a loan. Simply put, this means that the financial institution that agrees to lend money to a business has the right to seize and sell the items that are agreed upon collateral in order to compensate the lender for any loss it might incur if a borrower fails to repay the loan in full. Because of the ability to recoup its losses in case of default, a collateralized loan is much less risky for the lender and much easier to qualify for as a borrower, especially if there are any other weaknesses in your credit profile. According to the terms of the loan, the collateralized items must not be sold or transferred to another owner during the life of the loan. In certain situations, the financial institution may require physical possession of the collateral during the life of the loan; however, it is very typical for a business to retain its collateralized assets until the need arises to surrender the items to the bank in order to repay a loan that is in default.
Installment Loans: These types of business loans require repayment over the life of the loan through a number of regularly scheduled payments. The term of an installment loan may be as little as a few months or as long as 30 years.
Line of Credit: Often a small line of business credit is the first type of business loan that a financial institution will agree to lend a small business with newly established credit. Unfortunately, just like with personal credit, often the first lines of business credit issued to a newly established business are extended at relatively high interest rates and may have some significant fees associated with the loan. However, once the business owner has demonstrated the ability to make timely payments and ultimately repay the loan in full, the financial institution will be willing to increase the loan amount, decrease the interest rates, and reduce the fees.
Seasonal Commercial Loans: These types of loans are ideal for businesses whose inventory fluctuates from season to season. Typically the loan terms allow a business to borrow a certain amount of money during the time of the year when the company’s cash flow is lowest because its inventory is low or being developed. According to the terms of the loan, the business has until the end of the season to generate income by selling their inventory and repay the bank.
Small Business Association (SBA) Loan: The SBA does not typically deal directly with small businesses when it comes to loans. Instead, they offer special financing and incentives to local community development organizations and smaller financial institutions through government guarantees.
Term Loans: These kinds of loans are the most basic commercial loans available. Typically, term loans carry fixed interest rates, monthly or quarterly repayment schedules, and a set maturity date. Term loans are very appropriate for established small businesses that possess sound financial statements and a substantial down payment to minimize monthly obligations and total loan costs. Often, these types of loans are categorized into two classifications: intermediate-term loans and long-term loans. Intermediate-term loans usually run for fewer than three years and are repaid through fixed monthly installments or a balloon payment at the end of the life of the loan with repayment being fixed to the useful life of the asset being financed. On the other hand, long-term loans commonly have a term of more than three years. Most have a term between three and ten years, with some long-term loans running as long as 20 years. Most long-term loans require the collateral backing of certain assets and require either quarterly or monthly repayment. Often, limitations on additional financial commitments are built into the terms of the loan, and they sometimes require a certain amount of a company’s profits to be set aside to repay the loan commitment.