Few businesses are able to operate strictly on a cash basis, running their m day-to-day operations, paying employees, purchasing inventory, and so forth without occasionally taking on debt to provide the funds they need to cover cash shortfalls or to allow for expansion. Every industry and business has its up cycles and its down cycles, and loans provide a ready source of cash to help businesses get through those inevitable down cycles.
Loans are one of the most popular ways for businesses to obtain financing. As an indication of loan activity in the United States, the Small Business Administration alone holds a portfolio of some $45 billion in loans and loan guarantees (where the SBA agrees to cover losses to the lender in the event of default by the borrower). Without these loans, one thing is certain: Fewer small businesses would be in business today, and many more people would be looking for jobs.
One of the first things most businesses do when seeking capital is to apply for a loan. Few businesses have never received loans from financial institutions at one time or another in their existence. The most common loan types include
- A microloan sponsored by the Small Business Administration
- A line of credit from a commercial bank
- A long-term equipment loan from a large manufacturer’s captive financing company
In short, a loan is simply borrowed money that must be repaid to the person or business that provides it. How that money is repaid ‘” and the requirements to which the borrower must adhere to obtain the loan and remain in the lender’s good graces ‘” is what makes one loan different from another.
The world of commercial lending is chock-full of unique terminology. Not only will knowledge of the meaning of this jargon make you more comfortable when you’re talking to potential lenders, it also will help you be much better able to effectively analyze whether a loan will be advantageous to you. Here are some key lending terms for you to become familiar with before you dive into the lending pool:
- Term: The length of time the borrower has to repay the debt. In the case of a five-year loan, for example, the borrower is expected to repay the debt in full by the end of the five-year loan term.
- Short-term loan: A loan with a term of less than one year.
- Long-term loan: A loan with a term of one year or more.
- Principal: The amount borrowed.
- Interest: The fee paid currently or added to the loan amount ‘” most often expressed in percentage terms as an interest rate ‘” to pay the lender for providing and servicing the loan. Generally, the higher the risk, the higher the interest rate.
- Collateral: Something of value (a specific asset) that the borrower pledges to the lender in exchange for a loan. When a borrower takes a mortgage loan to buy a house, for example, the house is pledged as collateral for the loan. If the borrower defaults and discontinues making loan payments, the collateral is forfeited to the lender, who is then free to dispose of it as he or she wants.
- Down payment: The amount of cash paid by the borrower at loan inception to obtain a loan. The down payment reduces the loan amount, most often by a fixed percentage such as 5 or 10 percent.
- Payments: The incremental repayments of a loan from the borrower to the lender. Payments usually fall into two categories:
- Regular payments: Most often occurring on a monthy basis, where each payment repays a portion of the principal plus a charge for interest.
- Balloon payment: No regular payments are made, but the entire loan amount plus interest is due at the end of the loan term.
- Asset-based financing: A loan that requires the borrower to pledge its most valuable assets ‘” including things such as equipment and receivables ‘” in the event of default. requires a borrower to put on deposit with the lending institution as a condition of the loan.
- Clean up period: A specified period during the course of a loan (most often a line of credit) in which the borrower is required to pay off the loan, proving that the borrower is not overly dependent on the loan.
- UCC 1: A document that evidences a lender’s security interest in a borrower’s personal property.
- Personal guarantee: Sometimes a bank won’t agree to make a business loan unless the company’s owner agrees to guarantee the loan personally. If the company defaults on the loan and is unable to pay the debt, the lender has the right to pursue repayment directly from the owner’s personal assets. As a start-up, you may not be able to avoid personal guarantees, but you can reach an understanding with your banker about what has to be done to eliminate them in the future. Of course the quality of your personal finances affects the use of a personal guarantee, but more important, they will affect your ability to get a loan at all.
- Secured loan: A loan for which the borrower has pledged collateral that is generally considered less risky than an unsecured loan. Be sure to offer your least valuable assets as security whenever possible, saving your best for last (in other words, try to finance your inventories before your receivables, if you can). Keep the security narrow ‘” to one class of (or even specific) assets if you possibly can. Using the firm’s total assets as security precludes other financing options.
- Unsecured loan: A loan for which no collateral is pledged. Generally considered riskier than a secured loan, with higher interest rates as a result. It is almost impossible for a business to obtain an unsecured loan, although owners may be able to obtain unsecured personal loans depending on their own situation.