Small business loans are a useful financing tool for start-ups and established companies alike. Term loans, in particular, are a popular choice for businesses that desire a fixed repayment term. When considering a small business loan, it’s important to know what to look for in the loan offer.
Small Business Loan Agreement Basics
The loan agreement spells out the details of the small business loan. While the document can be complex, it is vital that you read through it carefully. You’ll have to acquaint yourself with certain borrowing terms. These include:
Interest / APR. The interest clause explains what type of rate the loan carries, how the rate is calculated and what the rate is. Term loans generally feature a fixed rate which stays the same for the life of the loan. If you’re applying for a 7(a) or 504 loan guaranteed through the Small Business Administration, you may have a fixed or variable rate.
A variable rate is tied to a market index, such as the LIBOR, and it can increase or decrease in tandem with fluctuations in its corresponding index.
Pay attention to the loan APR. This is a calculation of interest, taking into consideration all other fees associated with the small business loan. As such, it reflects the true cost of the loan.
Default Interest. In addition to the regular interest rate, you should also check to confirm if there is a default rate. This is a higher penalty rate that applies when you miss a loan payment.
Personal Guarantee. Lenders often require personal guarantees when granting loans to small business owners. A personal guarantee means you assume personal liability for the debt. The lender will be able to seek legal recourse against you personally, if the business defaults on the loan.
Repayment. In most cases, term loans are repaid according to a fixed schedule, so you always know when payments are due. In some instances, however, the lender may include an on-demand clause in the loan terms. This clause allows the lender to demand payment in full at any time, sometimes with as little as a 24-hour advance notice.
Comparing Multiple Loan Offers
When you have more than one loan offer on the table, it can be difficult to determine what the best choice is. Weighing each loan’s most important features can make that decision easier.
First, consider how much money each lender is offering versus the loan’s APR. Locking in a smaller loan than you need, at a lower rate, isn’t necessarily beneficial, if you have to supplement what you’re borrowing with another loan that carries a higher rate.
Next, look at the loan repayment term. A short-term loan may need to be repaid in one to three years; a 504 loan through the SBA can be amortized over a period of up to 30 years. You must know what repayment time frame works best for your business, and for the specific investment you’re making.
Finally, consider whether any collateral is required. While you will not need to pledge any personal assets for an unsecured loan, the interest rate on offer is typically higher. A term loan, on the other hand, may require you to offer collateral, depending on the loan’s purpose.
Can You Afford the Loan?
The remaining piece of the puzzle is determining whether your business is in a position to repay the loan. Analyzing your debt service coverage ratio (DSCR), can provide the answer to this question. DSCR assesses the cash flow you’ll have to cover the new debt obligations. It is calculated as the ratio of your net income to your annual debt obligation, including principal, interest and other fees. A DSCR of 2, for example, would mean the net income generated by your business can pay off the debt for the year twice over. If the loan payments will dramatically shrink your cash flow, you’ll have to consider how comfortable you’ll be working with a smaller margin each month.
Taking out a loan is not beneficial if it detracts from the profitability of your business in the long run. Pay attention to the fine print to confirm if it’s the right choice for you.
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