Guide to Small Business Loans
Debt can often be a necessary evil. Before taking on any debt, business owners should ask themselves some important questions that include such things as: How much money can you borrow? What’s the effective interest rate I am going to pay? What are my payments going to be and how often?
But there’s another question that owners should ask before agreeing to loan terms:
“Do I understand all the rates and fees associated with this loan?”
A business loan might look like a great deal until you calculate in fees, costs, and penalties you didn’t realize where imbedded into the loan agreement. As you may have heard before, the cliché “The Devil is in the details” couldn’t resonate more in analyzing a small business loan.
Here is a breakdown of important items when it comes to small business loans.
3 Types of Business Loans:
- Term Loan
A term loan is a loan from a bank for a specific amount that has a specified repayment schedule and a fixed or floating interest rate. For example, many banks have term-loan programs that can offer small businesses the cash they need to operate from month to month. Often, a small business uses the cash from a term loan to purchase fixed assets such as equipment for its production process.
A term loan is typically for equipment, real estate or working capital paid off between one and twenty-five years. The loan carries a fixed or variable interest rate, monthly or quarterly repayment schedule, and set maturity date. The loan requires collateral and a rigorous approval process to reduce the risk of repayment. A term loan is appropriate for an established small business with good financial statements and a substantial down payment to minimize payment amounts and total loan cost.
- Business Line of Credit (LOC)
A business line of credit is quite like personal lines of credit. The financial institution grants access to a specific amount of financing. However, no interest is incurred until the funds are tapped into. A business line of credit can be unsecured or secured (typically, by inventory, receivables or other collateral). Lines of credit are often referred to as revolving and can be tapped into repeatedly. For instance, if there is access to a $100,000 line of credit and $50,000 is taken out, access to the remaining $50,000, if necessary, remains. If all $50,000 is paid back, there is access to the entire $100,000 without having to reapply, one of the biggest benefits of a line of credit. Interest is only accrued on the amount funds that are employed.
- Small Business Administration Loans (SBA)
The Small Business Administration was essentially created to fill the obvious conflict of interest when it comes to loans and early stage businesses. Start-up businesses cannot provide a lot of the financial documents that traditional lenders require, and thus they have difficulty in securing a loan.
The government however, realizes the importance of small businesses and offers loans to entrepreneurs through the SBA. What makes these loans unique is that they are partially backed by the government (the bank usually gets 75% of the loan guaranteed by the Federal Government). In other words, it takes some of the risk away from the private lender, giving you access to competitive interest rates and a better chance at acquiring a loan. In comparison to traditional loans, SBA loans require more paper work. However, the loans are geared towards focused entrepreneurs who show promise in creating a successful business in the long run. The SBA offers both term loans, which are typically offered toward real estate transactions, and lines of credit, which are typically revolving credit facilities collateralized by accounts receivable, inventory and equipment.
Interest Rate Calculations:
- Interest Rate
You may or may not have a firm grasp on interest rates already:
An interest rate is what you pay on top of what you borrow (the principal amount) from a lender. Lenders charge interest so they can make a profit off letting people borrow their money. Generally speaking, the more risk your lender believes your business has, the higher your interest rate will be.
You can calculate your interest rate in two ways: as simple interest or as compound interest.
Simple interest is a straightforward calculation that considers the amount you’re borrowing, the annual interest rate, and the amount of time you’ll be paying the loan back. Here’s the formula:
Simple interest = Principal x Annual Interest Rate x Duration of Loan (Years)
Compound interest, on the other hand, is a bit more complicated. It compounds, or recalculates, your repayment based on monthly payments. When you repay a loan, you may wind up paying interest on interest in the end, and compound interest takes that into account.
Whichever formula you use to calculate your interest rate, the idea is the same. Your interest rate is the basic percentage of what you’ve borrowed that you’re paying back to the lender.
- Annual Percentage Rate (APR)
Interest rate is the barebones cost of borrowing, but APR is the all-inclusive calculation.
APR, or annual percentage rate, combines your interest rate with all sorts of different fees and costs associated with your business loan, many of which we’re about to go over. They’re all rolled up into one number that indicates the total cost of your loan.
Since 1968, the Truth in Lending Act mandated that lenders release the APRs of their loans in addition to their interest rates, so that consumers and business owners like you could compare your options apples to apples. That’s the real power of APR—letting you understand, between two loans, which one will cost more in total.
While knowing a loan’s APR is incredibly helpful, you shouldn’t forget about its interest rate. APRs take interest rates into account, but it can still be useful to split a loan’s costs into recurring expenses and one-time upfront fees. Use both numbers to make an informed decision about your business financials.
Fees & Costs for Business Loans:
Those are the rates to look out for—and here are a few common fees and expenses that business loans often come with.
- Origination Fee
Origination fees, usually expressed as a percentage of the principal you’re borrowing, are charged by lenders to “juice” the profit they will make on a loan.
This fee will vary lender by lender but typically will be in the 3% range. In other words, if you are borrowing $100,000 you may expect to pay as much as $3000 in origination fees.
- Application Fee
There is true cost in the due diligence and underwriting process. These fees will cover some of the costs lenders take on when processing your application, such as checking your credit, ordering a background check, pulling a D&B report on the business’ customers, or appraising your business property,
- Guarantee Fee
Guarantee fees only apply if you’re considering an SBA loan. The Small Business Administration doesn’t originate loans. Instead, it guarantees them for commercial banks. As a result, your lender will likely have to pay a portion of that guaranteed amount to the government and might very well pass that expense along to you.
- Late Payment Fee
Many lenders will charge you a fee if you make a late payment, which is why you should stay as organized as possible when budgeting for your small business. If your loan payments are taken directly from your account, make sure you have enough money, then set reminders to pay your lender to avoid this fee.
- Check Processing Fee
If you choose to pay your lender with checks rather than through debit or credit account transactions, don’t be surprised if you face a check processing fee as well. Processing checks often takes more time and manpower, which is why lenders don’t prefer this payment method.
- Underwriting Fee
Like application fees, the underwriting fee is how your lender recovers the time and money they spend underwriting your loan application. They evaluate your business’s financial statements and analyze historical trends and market data to figure out whether to offer you a loan, and what interest rate that loan should come with if you qualify.
- Prepayment Penalty
You’ll face a fee if you pay late, and possibly if you pay early, depending on your lender.
Not all loans come with prepayment penalties, and not all prepayment penalties are the same. The general idea is that lenders will often lose out on money they expected if you repay your principal before the loan matures. To prevent that loss, some lenders charge prepayment penalties. In some cases, it could be a flat fee. In others, you may have to repay all or a percent of the remaining interest.
Whether you wait, or pay early and accept this penalty, is up to you and your business needs. However, you should make sure you’re aware of any prepayment penalties in your loan contract before you sign.
Mr. Cox is Managing Principal with Pendleton Capital Group, Inc. – a factoring and trade financing company headquartered in Houston, TX. PCG provides professional “best practices” Factoring and Trade Financing and other small business services. His office is in Houston, TX, and he can be reached for additional information or consultation at [email protected] or 713-808-9746. The company’s website can be accessed at www.pendletoncapitalgroup.com