Business Loans - The Basics

A loan is based on a simple idea: Someone gives you money, and you promise to pay it back, usually with interest. The entire risk of your enterprise is placed on your shoulders. To help keep the risk low, a lender will very likely ask for security for the loan -- for example, a mortgage on your house so that the lender can take and sell your house if you don't keep up your loan payments.

If you're confident about the future of your business and you have the opportunity to borrow money, a loan is a more attractive source of money than getting it from an equity investor, who will own a piece of your business and receive a share of the profits. However, you don't have to repay equity investors if the business goes under.

In case you decide on a loan, here are the basics.

The Promissory Note
A lender will almost always want you to sign a written promissory note -- a paper that says, in effect, "I promise to pay you $XXX plus interest of XX%" and then describes how and when payments are to be made. A bank or other commercial lender will use a form with a bit more wording than our form, but the basic idea is always the same.

Sign only the original of the promissory note. When it's paid off, you're entitled to get it back. If you let signed copies float around, that can cast doubt on whether the debt has been fully paid. The only exception to that rule is a photocopy of the signed note marked "COPY" that you should keep for your business records. Keep that strictly confidential.

Repayment Plans
If the interest rate on the loan doesn't exceed the maximum rate allowed by your state's usury law, you and the lender are free to work out the terms of repayment.

Typically, a state's usury law will allow a lender to charge a higher rate when lending money for business purposes than for personal reasons. In several of these state laws, there's no limit on the interest rate that can be charged on business loans as long as the business borrower agrees to the rate in writing. In a few states, the higher limit or absence of any limit applies only when the business borrower is organized as a corporation. In other states, the higher rates permitted for business borrowers are legal even if the borrower is a sole proprietorship, partnership, or limited liability company. When checking your state's law, look under "interest" or "usury" in the index to your state's statutes.

If there aren't any usury law problems, you and the lender can agree on any number of repayment plans. Let's say you borrow $10,000 with interest at the rate of 10% a year. Here are some repayment possibilities:

  • Lump sum repayment. You agree, for example, to pay principal and interest in one lump sum at the end of one year. Under this plan, 12 months later you'd pay the lender $10,000 in "principal" -- the borrowed amount -- plus $1,000 in interest.
  • Periodic interest and lump sum repayment of principal. You agree, for example, to pay interest only for two years and then interest and principal at the end of the third year. With this type of loan plan, often called a "balloon" loan because of the big payment at the end, you'd pay $1,000 in interest at the end of the first and second years, and then $10,000 in principal and $1,000 in interest at the end of the third year.
  • Periodic payments of principal and interest. You agree, for example, to repay $2,500 of the principal each year for four years, plus interest at the end of each year. Under this plan, your payments would look like this:
    End of Year One: $2,500 principal + $1,000 interest
    End of Year Two: $2,500 principal + $750 interest
    End of Year Three: $2,500 principal + 500 interest
    End of Year Four: $2,500 principal + $250 interest
  • Amortized payments. You agree, for example, to make equal monthly payments so that principal and interest are fully paid in five years. Under this plan, you'd consult an amortization table in a book, on computer software, or on the Internet to figure out how much must be paid each month for five years to fully pay off a $10,000 loan plus the 10% interest. The table would say you'd have to pay $212.48 a month. Each of your payments would consist of both principal and interest. At the beginning of the repayment period, the interest portion of each payment would be large; at the end, it would be small.
  • Amortized payments with a balloon. You agree, for example, to make equal monthly payments based on a five-year amortization schedule, but to pay off the remaining principal at the end of the third year. Under this plan, you'd pay $212.48 each month for three years. At the end of the third year after making the normal monthly payment, there'd still be $4,604.42 in unpaid principal, so along with your normal payment of $212.48, you'd make a balloon payment to cover the remaining principal.

Avoid loans with prepayment penalties. Whenever you borrow money, you'd like to be free to reduce or pay off the principal faster than called for in the promissory note if you have the wherewithal to do so, since this reduces or stops the running of interest. In other words, if you have a three-year loan but are able to pay it off by the end of year two, you don't want to pay interest for year three. By law, some states always allow such early repayment, and you pay interest only for the time you have the use of the borrowed money. In other states, however, the law allows a lender to charge a penalty (amounting to a portion of the future interest) when a borrower reduces the balance or pays back a loan sooner than called for. Because it seems unfair to have to pay anything for the use of borrowed money except interest for the time the principal is actually in your hands, try to make sure any promissory note you sign says you can prepay any or all of the principal without penalty. If the lender doesn't agree, see if you can negotiate a compromise under which you'll owe a prepayment penalty only if you pay back the loan during a relatively short period, such as six months from the time you borrow the money.

Lenders usually require you to provide some valuable property -- called security, or collateral -- that they can sell to collect their money if you can't keep up with the loan repayment plan. A
lender, however, isn't limited to using the pledged assets to satisfy the loan. If you don't make good on your repayment commitment, a lender also has the right to sue you. Typically, a lender will seize pledged assets first and then sue you only if the funds realized from those assets are insufficient to pay off the loan, but that's not a legal requirement. If the lender wins the lawsuit, assets you haven't specifically pledged as security, such as a portion of your future earnings, are at risk.

If you lack the assets that you need as security for a loan, a microloan may be a good option for you. Generally, these loans are quite small -- often from $100 to $1,000. However, they can run up to about $25,000. The companies that qualify are generally those that can't get access to any other forms of capital, either because they're start-ups or because they're too small. Sometimes they're owned by people whose personal credit histories are good in general but might include problems that would scare off traditional lenders. Lenders that give microloans accept collateral that regular banks don't consider, like office equipment or the owner's home washer or TV set. Such lenders will also overlook some types of credit problems if they believe those problems have been solved. However, microloan interest rates are much higher than typical loan rates because their risks are higher: typically 12.5% to 15%. So, if you decide for a microloan, it is a good idea to qualify for one and use it to kickstart your company to the point that traditional bank financing becomes feasible. After that, a traditional loan will be a better option for you.

Cosigners and guarantors
Another option for you, in case you lack sufficient assets to pledge as security for a loan, is to get someone else to cosign or guarantee the loan. If you choose this option, the lender will have two people rather than one to collect from if you don't make your payments. Remember that the cosigner risks their personal assets if you don't repay the loan.

Getting the lender to choose you
Bankers look for an ideal loan applicant, who typically meets these requirements:

  • For an existing business, a cash flow sufficient to make the loan payments.
  • For a new business, an owner who has a track record of profitably owning and operating the same sort of business.
  • An owner with financial reserves and personal collateral sufficient to solve the unexpected problems and fluctuations that affect all businesses.
  • A good bet is the person who has worked for, or preferably managed, a successful business in the same field as the proposed new business. On the contrary, if you have managed a business in a different field than the one your current business is in, you are less likely to qualify. In such case, hiring a manager who has experience in your business field will be an advantage.
  • What is it that makes you think you will be one of the minority of small businesspeople who will succeed? Prepare some specific answers and you will stand out in the eye of the lender.
  • Lenders also look for commitment. Many people start their own business because they can't stand working for others. This is fine but not enough for a banker to believe in your success. Your personal commitment to the business and your passion about success will make a good impression.


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