Securing financing for your business is one of the most crucial steps in growing and sustaining your business, and understanding the key terms of a business loan is essential to make informed decisions. Whether you’re looking to launch a startup, expand your operations, or maintain day-to-day cash flow, understanding common business loan terms can save you from confusion and ensure that you’re aware of the financial responsibilities you’re taking on.

In this article, we’ll go over some of the most common business loan terms that you should familiarize yourself with. By understanding these terms, you can not only secure a business loan that fits your needs but also navigate the terms and conditions of the loan more efficiently, and avoid any hidden surprises.

Key Takeaways

• Understand the Key Loan Terms Before Borrowing: Knowing terms such as loan amount, interest rate, term length, collateral, and repayment schedule is critical for making an informed decision when applying for a business loan. Familiarizing yourself with these terms ensures that you understand the full cost and repayment obligations of the loan.
• Interest Rate and Loan Term Impact Your Total Repayment: The interest rate and term length will have a significant effect on the total amount you repay over the life of the loan. A lower interest rate and shorter term may help reduce your total repayment, but could also increase your monthly payments. A longer term might result in lower monthly payments but higher interest costs over time.
• Collateral and Personal Guarantees Pose Risk: Secured loans require collateral, which could put your business assets at risk if you fail to repay the loan. Personal guarantees may also make business owners personally liable, adding another layer of risk to consider when borrowing.
• Consider the Flexibility of the Loan: Different types of loans, such as term loans and lines of credit, offer varying levels of flexibility. While term loans are better for long-term investments, lines of credit provide more flexibility for short-term expenses. Choose the type of loan that best suits your business’s cash flow and financial needs.
• Be Aware of Fees and Other Charges: Lenders often charge fees such as origination fees, prepayment penalties, and late fees. These additional costs can increase the overall expense of the loan. Always ask the lender to clarify any fees involved and calculate them into the total cost of borrowing to avoid unexpected expenses.

Loan Amount

The loan amount is the total sum of money you borrow from a lender. This amount is based on your business’s needs, financial projections, and eligibility. Loan amounts can vary significantly depending on the type of loan and the lender’s policies. Typically, the larger the loan amount, the more documentation and due diligence will be required, such as a detailed business plan, financial statements, and sometimes collateral.

When you apply for a loan, it’s essential to borrow the amount you actually need. Borrowing more than necessary can increase the debt burden and make repayment more difficult. On the other hand, borrowing too little could hinder your business from meeting its operational or growth goals.

Interest Rate

The interest rate is the cost of borrowing money, expressed as a percentage of the loan amount. It is the lender’s fee for providing you with capital. The interest rate will significantly impact the total cost of the loan over time. There are two main types of interest rates:

• Fixed Interest Rate: This means that the interest rate remains constant throughout the life of the loan. It provides predictability and stability because your monthly payments will stay the same.
• Variable Interest Rate: This interest rate fluctuates over time, typically based on an underlying benchmark rate (like the LIBOR or prime rate). While this could result in lower initial payments, there is a risk that the rate could increase, causing higher payments down the line.

Term Length

The term length refers to the amount of time you have to repay the loan. Business loan terms typically range from one year to 10 years or more, depending on the size of the loan, the lender’s policies, and the type of financing.

Shorter term lengths often come with higher monthly payments but can save you money on interest in the long run. Longer term loans generally have lower monthly payments, but the total interest paid over the life of the loan can be higher. It’s essential to find the right balance between manageable monthly payments and the total cost of the loan.

Repayment Schedule

The repayment schedule outlines the frequency and amount of payments you must make toward your loan. Common repayment schedules include:

• Monthly payments: Payments are made once a month.
• Weekly or Biweekly payments: Payments are made more frequently (i.e., once a week or every two weeks).
• Balloon payments: This involves making small payments for a set period, followed by a large “balloon” payment for the remaining loan balance at the end of the term.

Your repayment schedule should align with your business’s cash flow to ensure that you can make timely payments without disrupting operations.

Collateral

Collateral is an asset that you pledge to the lender to secure the loan. If your business fails to repay the loan, the lender can seize the collateral as compensation for the unpaid debt. Collateral can come in the form of:

• Real estate: Commercial property or personal property like land or buildings.
• Equipment: Machinery or equipment used in the business.
• Inventory: Goods or products that are part of your business’s inventory.
• Accounts Receivable: The money owed to you by customers.

While offering collateral can make it easier to secure a loan and might lead to a lower interest rate, it also introduces risk. If your business doesn’t succeed or experiences financial trouble, you could lose the assets you’ve pledged.

Personal Guarantee

A personal guarantee is a commitment made by the business owner or another individual to repay the loan if the business is unable to do so. This is a common requirement for small businesses or startups that may not have sufficient business assets to pledge as collateral.

If the business defaults on the loan, the individual who signed the personal guarantee becomes personally liable for repaying the loan. This can put personal assets such as homes, savings, and other valuables at risk. Before signing a personal guarantee, it’s important to understand the level of risk involved.

Fees

In addition to the interest rate, lenders often charge various fees associated with the loan. These can include:

• Origination Fee: A fee charged by the lender for processing the loan application. This is typically a percentage of the loan amount.
• Prepayment Penalty: Some loans may charge a fee if you pay off the loan early. This is because lenders lose out on the interest they would have collected over time.
• Late Fees: If you miss a payment, you could be charged a late fee.
• Application Fee: Some lenders may charge an application fee for reviewing your loan request.

Understanding these fees is essential to determine the true cost of the loan. Always ask your lender for a complete list of fees before signing any agreement.

APR (Annual Percentage Rate)

The Annual Percentage Rate (APR) represents the total cost of the loan expressed as a yearly interest rate. It includes both the interest rate and any additional fees associated with the loan. The APR gives you a clearer idea of how much the loan will cost annually, allowing you to compare different loan offers more easily. The lower the APR, the less you will pay over the life of the loan.

Debt-to-Income Ratio

The debt-to-income ratio (DTI) is a metric used by lenders to assess your ability to manage monthly debt payments in relation to your income. A high DTI ratio indicates that you may have difficulty taking on additional debt, while a lower ratio suggests you have the financial capacity to handle a loan.

For businesses, lenders may look at both your personal and business DTIs when evaluating your loan application.

Secured vs. Unsecured Loans

Business loans can either be secured or unsecured:

• Secured Loans: These loans require collateral to back the loan. Because they are less risky for the lender, secured loans often come with lower interest rates. However, they also put your business assets at risk.
• Unsecured Loans: These loans do not require collateral. They are based on your business’s financial health and your creditworthiness. Because unsecured loans are riskier for lenders, they typically come with higher interest rates.

Loan-to-Value Ratio (LTV)

The Loan-to-Value Ratio (LTV) is a metric used by lenders to assess the value of the collateral compared to the loan amount. It is calculated by dividing the loan amount by the appraised value of the collateral.

For example, if you are securing a loan with real estate as collateral, and the property is worth $100,000, but you borrow $80,000, the LTV ratio is 80%. Lenders typically prefer lower LTV ratios because they reduce the lender’s risk. A high LTV ratio may make it harder to secure a loan or result in higher interest rates.

Understanding the LTV ratio can help you determine if your collateral is sufficient to secure the loan amount you need, and whether or not you may need to adjust your expectations based on the value of your assets.

Covenants

Covenants are conditions set by lenders to ensure that a borrower remains in good financial standing throughout the life of the loan. There are two main types of covenants:

• Affirmative Covenants: These require the borrower to take specific actions, such as submitting financial statements or maintaining a certain level of insurance.
• Negative Covenants: These prevent the borrower from taking specific actions, like taking on additional debt or selling assets without the lender’s approval.

Covenants are important because they impose restrictions that can affect your business’s flexibility. Be sure to understand any covenants imposed by the lender, as violating them could result in penalties or loan default.

Credit Score

Your business credit score plays a significant role in determining the terms of your loan. Lenders typically look at your credit score to gauge your ability to repay debts. A higher credit score can lead to better loan terms, such as lower interest rates or higher loan amounts, while a lower score might result in higher interest rates, stricter repayment terms, or even loan denial.

If you’re a new business without an established credit history, lenders may evaluate your personal credit score instead. Having a solid credit history, both personally and for your business, can significantly impact your ability to secure a loan with favorable terms.

Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio (DSCR) is another key metric used by lenders to evaluate your business’s ability to service its debt. It is calculated by dividing your business’s operating income by its debt obligations. A DSCR of 1 means your business is generating just enough income to cover its debt obligations. A ratio higher than 1 indicates that your business has more income than required to meet its debt payments, which is viewed favorably by lenders.

For example, if your business generates $500,000 in operating income and owes $400,000 in debt, your DSCR is 1.25, which means you are earning 25% more than necessary to cover your debt obligations. A higher DSCR reduces the risk for lenders and increases your chances of loan approval.

Subordination

Subordination refers to the order of repayment in the event of a loan default or bankruptcy. If your business has multiple loans, some loans may be subordinated, meaning they are paid after other, senior debts in the repayment hierarchy. Subordinated loans tend to have higher interest rates due to the added risk to the lender.

Understanding the subordination of your business debt can help you better plan for repayment and assess how new loans might affect existing debt obligations. Be aware of the implications of subordinating your debt, as it could impact your ability to secure future financing.

Balloon Payment

A balloon payment is a large, lump-sum payment due at the end of the loan term, after making smaller regular payments throughout the life of the loan. Balloon payments are often associated with loans that have a short term but offer lower monthly payments. This is particularly common in commercial real estate loans.

While balloon payments can help lower monthly payments in the short term, they come with the risk of requiring a large sum of money to pay off the loan in full at the end of the term. It’s essential to plan for a balloon payment and ensure that you have sufficient funds available when the payment is due.

Lines of Credit vs. Term Loans

Understanding the difference between a line of credit and a term loan is essential for any business owner looking to secure financing:

• Term Loans: These are traditional loans where you borrow a lump sum of money upfront and repay it over time with interest. The term length, interest rate, and repayment schedule are fixed, making it easier to budget for your loan payments.
• Lines of Credit: A line of credit is a revolving loan that allows you to borrow money up to a certain limit, repay it, and then borrow again as needed. Unlike term loans, lines of credit offer flexibility and can be used for various short-term expenses. However, they often come with variable interest rates.

Understanding the advantages and disadvantages of both options will help you choose the financing that best suits your business’s needs.

Also Read: What You Need To Know About For Business Loans Startups

Conclusion

Understanding common business loan terms is essential for making informed financial decisions that align with your business goals. From loan amounts and interest rates to repayment schedules and collateral requirements, knowing these terms can help you evaluate the costs and benefits of different loan options.

Securing financing is a critical step in growing your business, and being fully aware of the terms associated with any loan is key to ensuring you manage your debt effectively and responsibly.

FAQs

What’s the difference between a fixed and a variable interest rate?

A fixed interest rate remains the same for the entire duration of the loan, while a variable rate can change based on market conditions.

What is a personal guarantee, and do I need one for my business loan?

A personal guarantee is a promise to repay the loan if your business cannot. It may be required if you are a new business owner or have limited collateral.

How does a business’s credit score affect my loan application?

A higher credit score typically increases your chances of securing a loan with favorable terms. Lenders use your credit score to assess your reliability as a borrower.

Can I use a business loan for any purpose?

It depends on the loan type. Some loans, like equipment financing, must be used for specific purposes. For general business loans, the funds can often be used more flexibly.

What happens if I can’t make a loan payment?

Missing a loan payment can result in late fees, a damaged credit score, and even loan default. In the worst case, the lender may seize collateral if it’s a secured loan.

Are there penalties for paying off a loan early?

Some loans have prepayment penalties, so it’s important to check the loan agreement before paying off the loan early to ensure you are not penalized.

How long does it take to get approved for a business loan?

Loan approval timelines vary depending on the lender and loan type. Traditional bank loans may take weeks, while online lenders can approve loans within a few days.