Business loans can be complicated creatures that come in all shapes and sizes. Choosing the wrong one can leave you in strife, but knowing which is right for you is a challenge.
Below we explain the key elements of a few different loans and what you need to consider before applying – so you can spend less time online and more time working on what you love.
First Steps Towards Applying for a Business Loan
As a first step, you should check your credit history. This is how risky you look to lenders. Even paying your utility bills late can affect your rating, so try to keep up with all of your payments, all the time.
Credit history information is held by private agencies but you can access it for free. Ensure you ask for a report at least once a year and don’t allow them to charge you for ‘premium’ information.
Next, you need to work out what the loan is needed for. Make sure it’s necessary for your business’ success and calculate how much money you’ll need. Underestimating will leave you unable to make the necessary improvements and overestimating will make lenders question your credibility. Budget everything and have a clear plan. It’ll give you and your lender peace of mind.
Once you’ve done this, you can select the loan which is right for you. Below is a brief summary of each type of loan you may need for your business.
What You Need to Know
Your interest rate can be fixed or variable.
With a fixed interest loan, you pay the same amount of interest back to the lender in each monthly instalment. This simplifies budgeting because you can easily keep track of what you’re paying and rate rises don’t matter. However, you will miss out on savings if interest rates go down. They may also charge break fees if you change your loan or pay it off early.
In variable interest loans, the amount of interest varies depending on the interest rates at the time. Unlike most fixed interest loans, you can make extra loan repayments if it suits you. Businesses are usually drawn to variable loans during periods of low interest rates. But they are riskier than fixed loans. You can save money if you time it well, but can end up paying more if there’s a rate rise.
Lenders also try to avoid risk by offering secured loans. The lender gives you money but they secure a portion of your property (collateral) in case you can’t repay the loan. This is often realty. Once you’ve repaid the loan they give you back your property rights.
Unsecured loans are the other side of the coin. Banks are usually unwilling to offer unsecured loans because they are considered too high risk. While unsecured loans don’t require you to give the bank any of your property, they have much higher fees. Lenders also often ask for a guarantor, someone who has to make repayments on your behalf if you default.
Types of Business Loans
Business term loan
The business term loan is your stock-standard loan. The lender gives you a lump sum of credit and you pay that back over a designated period with interest. It can have a fixed or variable interest rate and be secured or unsecured. They are favoured by many businesses because they usually offer low, fixed interest rates. However, small-to-medium businesses can find them difficult to get because lenders ask for a strong credit history as well as collateral.
Business line of credit
Most businesses have cash flow problems at different times. Having a business line of credit is preparation for a rainy day. It’s usually short-term funding often used for payroll, supplies and increasing your working capital when cash flow is low. The lender will allow you to draw on a specific amount whenever you need it and you only pay interest on what you use. It’s best to apply when you have cash as lenders will see you as a lower risk. Note, however, that lenders may also request payment at any time and charge you a fee if you default.
A business overdraft is a short-term credit option when you need extra cash. This credit ranges from $500 to $10,000 and can be secured or unsecured. There is often high administration charges and interest. Ensure you don’t overspend. The lender can ask for payments at any time and if you can’t do it immediately there can be penalties.
If you need cash immediately, factoring is an option. A factoring finance company will buy your invoices at a discount rate (typically 80% of your total invoice value). They then collect the profit from your invoices when it comes in and charge you a fee for their service. Factoring could prove risky if your clients fail to pay your invoices on time, resulting in the lender charging you a higher fee. Ensure you use invoices from reliable clients and this can be avoided.
With invoice financing, the lender extends you credit at the cost of a fee. You then pay the lender back with interest when the money from your invoices comes in. Invoice financing is good because it improves your cash flow and it usually doesn’t take any of your assets as collateral. However, invoice financing should not be used regularly because the fee structure will decrease your profit margins in the long term.
Business credit cards
Many small-to-medium-sized businesses use business credit cards as their sole credit card. Lenders often offer an interest free period, but you’ll need to pay off your balance on time. Unsecured credit is also an option. Business credit cards allow you to immediately increase your cash flow but this is likely to come at the cost of higher fees and interest.
When you need expensive equipment or plant, equipment financing is a good idea. There are four main options for this: operating leases, hire purchases, financial leases and chattel mortgages.
With operating leases, the lender pays for all the running costs of the equipment while you use it. They still own it and you hand it back after the period has ended.
Hire purchases require you pay to off the equipment in instalments. You can terminate the agreement at any time and are under no obligation to purchase it at the end of the period.
In financial leases, you pay for all the running costs as well as instalments when it suits you. There is usually a fixed interest rate and an option to buy the equipment at the residual value (what it’s worth after depreciation). Your repayments may also be tax deductible.
Chattel mortgages work in a similar way to other mortgages. You buy and own the equipment using money from the lender. You pay the running costs, instalments to the lender and a fixed interest rate. Additional security is usually not needed.
If you need more assistance with choosing the right business loan for your financial situation, get in touch with us here.