7 Things to Watch for in a Small Business Loan
Small business loans are a reliable way to get some extra capital for your business. Whether you’re using a loan to cover your startup costs (such as landing an office space) or to fuel a new initiative (such as investing in new equipment or new product development), getting a loan is both exciting and nerve-wracking.
If you aren’t careful, you could end up with a loan that’s nearly impossible to pay back, or one with unfavorable terms, and depending on the terms and conditions, you could even be held personally liable for that debt. That’s why it’s important to pay attention to the type of loan you’re getting, and how you’re getting it.
What to Look for in a Small Business Loan
These are some of the most important considerations you’ll need to bear in mind when shopping for a small business loan:
1. Interest rates. By now, you should be familiar with the power of compound interest. The interest rate you’re able to secure will have an exponential influence on the amount of money you eventually owe. For example, assuming your principal isn’t decreasing (for the sake of simplicity), if you end up borrowing $100,000 with a 4 percent interest rate, if that rate is compounded annually, you’ll end up paying back $21,665 in interest—which is far more than four individual years of $4,000 in interest ($16,000). You’ll also need to consider how often that interest rate is compounding, which refers to how often the proportional interest rate is applied to your principal. An interest rate that compounds daily, by contrast, would result in $22,138 in interest. That’s not a huge difference in this example, but it could be depending on the other structure of your loans.
Obviously, you want the lowest interest rate possible, but the interest rate you get will depend on a number of factors, including your credit history and the terms of the loan you’re seeking. You’ll find that most lending institutions will be in close competition with one another, so if you want a lower interest rate, you may have to sacrifice some other preference to compensate for it.
2. Next, you’ll need to consider the terms of the loan—in other words, the length of time you’re going to spend paying off the loan. If you’re thinking long-term, or if you don’t have an existing stream of revenue to help you with the monthly payments, you might consider the longest term possible, ranging many years into the future. However, there are many risks associated with those long-term loans; the longer period of time means you’ll end up paying more interest unless you end up paying off the principal ahead of schedule. Do be aware, however, that paying off your loan early can result in a prepayment penalty—so pay attention to that in the conditions of the loan.
3. Your loan conditions cover a number of stipulations that apply to how you can use the money, how and when you’re allowed to pay the loan back, and what will happen if you break any of those rules (including failing to pay back the loan). For example, are you required to make monthly payments? If so, is there a minimum amount you’ll owe? What happens if you’re late with the payment—is there a penalty? Is there a penalty for paying off the debt too early?
Conditions may also apply to how you’re able to use the funds in some cases, especially if you’re dealing with a private lender. If this is the case, you may incur a penalty if you’re found to use the funds for some reason other than what was specified in the initial agreement. Finally, you’ll need to consider whether the loan is secured or unsecured, and what the penalties are for non-payment. Unsecured loans are harder to get, and sometimes come with higher interest rates, but they aren’t “secured” by a piece of collateral. You’ll still be liable for covering the debt (either with business assets or personal assets, depending on your business structure), but if you’ve just started your business, you may not have many assets to draw from. Secured loans, on the other hand, require you to have some kind of property, a piece of equipment, or another asset that can be used to cover the principal in the event that you aren’t able to pay it back.
4. If you’re starting a business and you want to invest in expansion, you may be tempted to get the most amount of money you qualify for; after all, having access to more capital gives you more flexibility, and will save you time if you end up needing to borrow more. However, if you want to be responsible and pay back your loan as quickly as possible within the terms and conditions, it’s better to have a formally documented plan for how you’re going to spend the money (and how you’re going to pay it back).
Start by outlining the fundamental costs you need to cover for your business. These may be things like an office building, pieces of equipment, or employees you need to continue operations. Don’t just guess or estimate based on your whims—do your research, talk to your mentors and peers, and calculate your best guess for what these needs will cost.
Then, use your financial models to project how much revenue you’ll be able to draw (and how fast you’ll be able to draw it). This information should, cumulatively, help you understand how much money you need and whether it’s feasible to pay it back in a timely manner. Estimate conservatively here, and try not to borrow more than you really need.
5. There isn’t just one type of “business loan” available; there are actually many different subtypes. An installment loan, for example, is what most people view as a “conventional” loan. It works like a mortgage payment, with your business paying back a fixed amount every month in a combination of principal and interest so that the loan is paid back by a specific date. However, you might also choose to adopt a “balloon loan,” in which you’ll pay only interest throughout the course of the loan. At the end of the loan period, you’ll be responsible for paying back the full sum of the principal.
You may also elect to adopt a line of credit, rather than a lump sum loan. This line of credit works similar to a credit card, allowing you to flexibly withdraw against a specified maximum and pay it back as you see fit. There are many different types of credit lines you can get, too, so consider your options before moving forward.
6. Financial institution. Next, you’ll need to consider the type of financial institution you get the loan from. Clearly, you’ll want to go with the provider that can offer your business the best deal, but the working relationship you’ll have with the loan provider also matters. For example, do you have a dedicated account rep who can answer your questions and help you if you encounter a problem? Do you have other accounts at this financial institution that will make it easier to manage your finances? Having a history with one institution may increase your likelihood of getting a better deal with them in the future, so consider this as you choose institutions for your loans, lines of credit, and checking accounts.
7. Your qualifications. Though not technically a quality of a loan, you’ll also need to pay close attention to your business’s (and your personal) qualifications for the loan. Banks are reluctant to lend to businesses with an unproven track record, or those with only a tenuous ability to pay a loan back. If you’re an existing business, banks want to see at least three years of history, including your profitability and the average value of your invoices. If you’re just getting started, your business plan and financial projections will come under heavy scrutiny, and your personal credit will be audited. If your business and personal history aren’t in order, you’ll need to spend some time polishing them before you take the next step; even if you do qualify, you’ll get a better deal if the bank sees you as more stable and reliable.
Taking the Next Step
By the end of this guide, you’ll have walked through some of the most important considerations for getting a business loan, and you should have a good idea about what you’re looking for. The next step is to start meeting with different lenders in your area, seeing what they have to offer and how those offers compare to your main priorities. If you need help getting started, the Small Business Administration has a great guide on the subject. Be sure to read the fine print carefully, and only move forward when you’re confident about the long-term benefits (and potential repercussions) of your decision.