Much like trying to pick the right loan for a home mortgage, you’ll likely be overwhelmed by the many types of small business loans your bank makes available.
And, much like a mortgage, one loan option usually floats to the surface as the best fit for you and your situation. Discerning which loan is the right choice isn’t necessarily a matter of one type being better than the other.
Focus on the two of major characteristics that vary among bank loans:
- The term of the loan
- The security or collateral required to obtain the loan
Understanding Loan Terms
The term of the loan refers to the length of time you have to repay the debt. Debt financing can be either long-term or short-term.
Common Applications for Long-Term and Short-Term Financing
Long-term debt financing is commonly used to purchase, improve or expand fixed assets such as your plant, facilities, major equipment and real estate.
If you are acquiring an asset with the loan proceeds, you (and your lender) will ordinarily want to match the length of the loan with the useful life of the asset. For example, the shelf life of a building to house your operations is much longer than that of a fleet of computers, and the loan terms should reflect that difference.
Short-term debt is often used to raise cash for cyclical inventory needs, accounts payable and working capital.
In the current lending climate, interest rates on long-term financing tend to be higher than on short-term borrowing, and long-term financing usually requires more substantial collateral as security against the extended duration of the lender’s risk.
Key Differences Between Secured or Unsecured Debt
Debt financing can also be secured or unsecured. Unfortunately, these terms don’t mean how secure or unsecure the debt is to you, but how secure or unsecure the debt is to the lender.
The Price of Secured Loans
No matter what type of loan you take, you promise to pay it back. With a secured loan, your promise is “secured” by granting the creditor an interest in specific property (collateral) of the debtor (you).
If you default on the loan, the creditor can recoup the money by seizing and liquidating the specific property used for collateral on the debt. For startup small businesses, lenders will usually require that both long- and short-term loans be secured with adequate collateral.
Because the value of pledged collateral is critical to a secured lender, loan conditions and covenants, such as insurance coverage, are always required of a borrower. You can also expect a lender to minimize its risk by conservatively valuing your collateral and by lending only a percentage of its appraised value. The maximum loan amount, compared to the value of the collateral, is known as the loan-to-value ratio.
A lender might be willing to lend only 75 percent of the value of new commercial equipment. If the equipment was valued at $100,000, it could serve as collateral for a loan of approximately $75,000.
Types of Bank-Offered Financing
Now that you’re familiar with the most important aspects of bank loans, it’s important to become familiar with the most common types of loans given by banks to startup and emerging small businesses:
- Working capital lines of credit for the ongoing cash needs of the business
- Credit cards, a form of higher-interest, unsecured revolving credit
- Short-term commercial loans for one to three years
- Longer-term commercial loans generally secured by real estate or other major assets
- Equipment leasing for assets you don’t want to purchase outright
- Letters of credit for businesses engaged in international trade
Working Lines of Credit and Credit Cards
A line of credit sets a maximum amount of funds available from the bank, to be used when needed, for the ongoing working capital or other cash needs of a business.
Consider a line of credit a loan that functions like a checking account. In most cases you’ll receive a checkbook for your line of credit so you can write checks on the fly without dipping into your own cash. Some may offer debit cards, or you can visit the bank to withdrawal cash. It is, of course, still a form of financing that must be repaid with interest.
Common Terms for Lines of Credit
As you consider a line of credit, you’ll find most fall within these broad categories:
- Lines are typically offered for renewable periods that range from 90 days to several years.
- Extended periods are usually subject to annual reviews by the lender.
- Maximum amounts vary greatly, from $10,000 to several million dollars.
- Interest rates usually float, and you pay interest only on the outstanding balance.
Most small business owners typically use their lines for daily operations, such as inventory purchases, and to cover periodic or cyclical business fluctuations. Collateral for the loan is often accounts receivable or inventory.
From a lender’s perspective, the adequacy of your cash flow is the most critical consideration. A commitment fee may be assessed by the bank for making a line of credit available to the borrower, even if the full amount is never used. Established businesses with sound credit histories have the best bet of obtaining unsecured revolving lines of credit.