In their book Start Your Own Business, the staff of Entrepreneur Media Inc. guides you through the critical steps to starting your business, then supports you in surviving the first three years as a business owner. In this edited excerpt, the authors outline the seven different kinds of loans you could get from a bank.
When you're looking for debt financing for your business, there are many sources you can turn to, including banks, commercial lenders, and even your personal credit cards. And you don’t need to pinpoint the exact type of loan you need before you approach a lender; they will help you decide what type of financing is best for your needs. However, you should have some general idea of the different types of loans available so you'll understand what your lender is offering.
Here's a look at how lenders generally structure loans, with common variations.
1. Line-of-credit loans.
The most useful type of loan for small-business owners is the line-of-credit loan. In fact, it’s probably the one permanent loan arrangement every business owner should have with their banker since it protects the business from emergencies and stalled cash flow. Line-of-credit loans are intended for purchases of inventory and payment of operating costs for working capital and business cycle needs. They're not intended for purchases of equipment or real estate.
A line-of-credit loan is a short-term loan that extends the cash available in your business’s checking account to the upper limit of the loan contract. Every bank has its own method of funding, but, essentially, an amount is transferred to the business’s checking account to cover checks. The business pays interest on the actual amount advanced, from the time it's advanced until it's paid back.
Line-of-credit loans usually carry the lowest interest rate a bank offers since they're seen as fairly low-risk. Some banks even include a clause that gives them the right to cancel the loan if they think your business is in jeopardy. Interest payments are made monthly, and the principal is paid off at your convenience, though it's wise to make payments on the principal often.
Most line-of-credit loans are written for periods of one year and may be renewed almost automatically for an annual fee. Some banks require that your credit line be fully paid off for seven to 30 days each contract year. This period is probably the best time to negotiate. Even if you don’t need a line-of-credit loan now, talk to your banker about how to get one. To negotiate a credit line, your banker will want to see current financial statements, the latest tax returns, and a projected cash-flow statement.
2. Installment loans.
These loans are paid back with equal monthly payments covering both principal and interest. Installment loans may be written to meet all types of business needs. You receive the full amount when the contract is signed, and interest is calculated from that date to the final day of the loan. If you repay an installment loan before its final date, there will be no penalty and an appropriate adjustment of interest.
The term of an installment loan will always be correlated to its use. A business cycle loan may be written as a four-month installment loan from, say, September 1 until December 31 and would carry the low interest rate since the risk to the lender is under one year. Business cycle loans may be written from one to seven years, while real estate and renovation loans may be written for up to 21 years. An installment loan is occasionally written with quarterly, half-yearly, or annual payments when monthly payments are inappropriate.
3. Balloon loans.
Though these loans are usually written under another name, you can identify them by the fact that the full amount is received when the contract is signed, but only the interest is paid off during the life of the loan, with a “balloon” payment of the principal due on the final day.
Occasionally, a lender will offer a loan in which both interest and principal are paid with a single “balloon” payment. Balloon loans are usually reserved for situations when a business has to wait until a specific date before receiving payment from a client for its product or services. In all other ways, they're the same as installment loans.
4. Interim loans.
When considering interim loans, bankers are concerned with who will be paying off the loan and whether that commitment is reliable. Interim loans are used to make periodic payments to the contractors building new facilities when a mortgage on the building will be used to pay off the interim loan.
5. Secured and unsecured loans.
Loans can come in one of two forms: secured or unsecured. When your lender knows you well and is convinced your business is sound and the loan will be repaid on time, they may be willing to write an unsecured loan. Such a loan, in any of the aforementioned forms, has no collateral pledged as a secondary payment source should you default on the loan. The lender provides you with an unsecured loan because it considers you a low risk. As a new business, you're highly unlikely to qualify for an unsecured loan; it generally requires a track record of profitability and success.
A secured loan, on the other hand, requires some kind of collateral but generally has a lower interest rate than an unsecured loan. When a loan is written for more than 12 months, is used to purchase equipment, or does not seem risk-free, the lender will ask that the loan be secured by collateral. The collateral used, whether real estate or inventory, is expected to outlast the loan and is usually related to the purpose of the loan.
Since lenders expect to use the collateral to pay off the loan if the borrower defaults, they'll value it appropriately. A $20,000 piece of new equipment will probably secure a loan of up to $15,000; receivables are valued for loans up to 75 percent of the amount due; and inventory is usually valued at up to 50 percent of its sale price.
6. Letter of credit.
Typically used in international trade, this document allows entrepreneurs to guarantee payment to suppliers in other countries. The document substitutes the bank’s credit for the entrepreneur’s up to a set amount for a specified period of time.
7. Other loans.
Banks all over the country write loans, especially installment and balloon loans, under a myriad of names. They include:
- Term loans, both short- and long-term, according to the number of years they're written for
- Second mortgages where real estate is used to secure a loan; usually long-term, they’re also known as equity loans
- Inventory loans and equipment loans for the purchase of, and secured by, either equipment or inventory
- Accounts receivable loans secured by your outstanding accounts
- Personal loans where your signature and personal collateral guarantee the loan, which you, in turn, lend to your business
- Guaranteed loans in which a third party—an investor, spouse, or the SBA—guarantees repayment
- Commercial loans in which the bank offers its standard loan for small businesses