This is probably the type of loan most Main Street business owners think of when they head to the bank looking for a loan. In its simplest terms, a term loan is repaid in regular payments over a period of time. Auto loans and home mortgages are both great examples. Amounts and repayment terms vary depending upon the amount borrowed and the credit worthiness of the borrower, but both loan types are term loans.
It’s Usually Buried in the Small Print
They call it “mouse type” in the biz. It’s the itty-bitty type at the bottom or backside of the page that only a mouse can read. It outlines all the terms and conditions associated with a term loan. This is true for any loan not just term loans, and it’s a good idea to read it and make sure you understand it. Unfortunately, it’s usually filled with a lot of legal jargon and the size of the type is actually designed to make it difficult to read. But regardless of your desire to gloss over it, ignoring the fine print can cost you a lot of money and heartache down the road.
Two questions you’ll want to answer in the fine print are:
Is your interest rate fixed or floating? A fixed rate of interest means the percentage of interest will never change over the term of your loan, regardless of the financial markets. A good time to take out a fixed rate loan is when interest rates are low. Floating interest rates fluctuate with the market. When interest rates are generally low, you will enjoy a lower interest rate on your business loan. When rates go up, so will the interest rate on your loan. So having an adjustable rate loan could be good or bad depending upon what happens with the economy.
Is it simple or compounding interest? It’s amazing how such simple concepts can be so confusing and expensive if you don’t fully understand them. In a nutshell, simple interest is calculated only on the principal amount. In other words, interest is computed on the amount of the loan that remains unpaid at any given time. The formula looks like this:
Although this is a very simple example, notice that in year two of the compounding interest, you must pay interest on your principal as well as on the outstanding $50 in interest due. It is expected that regular payments will be made over the course of the loan; the calculations would reflect a monthly payment schedule rather than a yearly payment schedule. Typically, in the beginning, most of the payment is applied toward paying the interest, with a smaller percentage going toward the principal. As the loan matures over time, this ratio changes and more of the principal is paid off with each payment.
As you might guess, if you anticipate paying off your loan early, a simple interest loan is better. Principal and interest are paid off at the same rate. Because a compounding interest loan is weighted with more interest at the front end of the loan, it may feel as if you are being penalized for prepayment.
Could a Term Loan be Just Right for You and Your Business?
Goldilocks taught us that one size does not fit all, which is why a term loan might not be the right fit for your business. That being said, there are some great advantages to term loans:
- Immediate access: Most people are familiar with an auto loan or home mortgage. The entire loan amount is immediately available to purchase equipment, fund working capital, fuel growth, and so on.
- It’s like clockwork: Budgeting is a piece of cake. You can anticipate your payment and make sure your business allocates funds every month to pay the monthly obligation. There are seldom surprises.
- Nothing is arbitrary: Your bank will charge you the agreed-upon rate. There are no arbitrary-feeling interest rate hikes regardless of what’s happening in financial markets.
- The books are easy: Accounting entries for loan payments are straightforward and easy to reconcile. This isn’t an accounting nightmare.
- Slow and steady wins the race: This is a great way to establish or improve your company’s business credit. Making regular payments over time demonstrates your credit-worthiness to the bank for subsequent (and potentially greater) access to financing.
Despite some of the advantages of a term loan, it isn’t all peaches and cream. There are some disadvantages too:
- Change is hard: If you get in a bind, or for any reason need to change the terms of your loan, you will need to go through the process of applying and qualifying for a new loan. Waiting until you’re in dire straits to go through this process is not a good idea. If you have a good relationship with your banker, he may have ideas as to how to approach the bank before things go completely south (see previous chapter).
- You could be left holding the bag: If interest rates go down, you could be paying a higher-than-market interest rate for your loan. Make sure you can live with the interest rate and are willing to either bite your tongue or find another loan should rates drop.
- Another loan might not be an option: Even if you’re prepared to find another loan, some loans include pre-payment penalties that make jumping ship for a lower interest rate problematic.
A Line of Credit
Although most people are looking for a term loan, a line of credit probably comes in a close second. Unlike a term loan, a line of credit is a source of funds that you can draw against when the need arises. Additionally, interest is paid only on the amount of funds used. For example, if you have a $10,000 line of credit but access only $5,000 to purchase a new piece of equipment, you pay interest and make payments only on the $5,000 you used.
Although it’s not exactly the same, this type of financial instrument is not that different from how trade was conducted in the early days of banking when Italian, Dutch, and English bankers offered a line of credit to international traders buying and selling goods throughout the world. You might also be interested to know that this type of financing was once the most common currency in international trade finance.
Today, a line of credit comes in many different forms. The most relatable is your bank overdraft protection. I don’t think most people think of it as a line of credit, but fundamentally, when you overdraw your personal checking account and the bank covers the amount, they do it with a loan. It’s likely you have a fixed amount over which your bank or credit union won’t honor your checks. It might be $800, $1,000, or more. In reality, that’s a line of credit associated with your checking account.
One More Thing
Ultimately, the best time to apply for a loan is when you’re prepared. If “your ducks are in a row,” as my grandmother used to say, other timing considerations become secondary. In my opinion, your ability to repay the loan is the single most important timing consideration. With that in mind, I wrap up this chapter by covering the factors your banker considers as you prepare your business case. In other words, the reasons why you need the loan, how you’re going to repay the loan, and what you’ll do should something unforeseen happen:
- Projected revenue: Your banker will likely want to see that A + B = C. If he extends a line of credit or a term loan to your business, how is that infusion of cash going to impact your bottom line? For example, if you are borrowing to facilitate expansion, where will you spend the loan amount and what is your expected return? A small business owner I know wanted to expand into a new and bigger space. He wasn’t looking for buckets of cash; actually it was a rather small loan by most people’s standards. But the $10,000 he was looking for would allow him to lease a new space, and it included some cash for additional marketing to ensure they were also finding new customers. He could demonstrate a reasonable return on the investment and his loan was funded. A + B = C is what your banker wants to see.
- Projected expenses: You banker will also want to know the total cost of your plans. If you can’t justify your expenditure of borrowed money with a positive ROI (return on investment) that demonstrates your ability to repay your loan, you’ll likely leave the bank empty handed. The world of finance is a world of projections, assumptions, and best guesses as much as anything else. If you’re not prepared to show the bank what you expect to happen, the timing isn’t right.
- Having skin in the game: You read about this in an earlier chapter, but it bears repeating. You banker wants to know the total cost of what you want to do and whether you’ve invested your own assets—that you have skin in the game.
- If the market will respond: Your banker will want to know that this isn’t a crap shoot. Even when you’ve made some personal investment in this endeavor, if you can’t convince your banker that the market will respond and you have a reasonable chance of success, they’ll likely pass. Nobody likes to throw good money after bad, particularly your banker.
- Having a contingency plan: If things in the market turn south, what then? Contingency plans and risk-mitigation strategies resonate with bankers. If you can demonstrate that you have a plan should things go south, you’ll have a better chance of securing the financing you need. What’s more, it’s always good to imagine “what if?” scenarios when you’re looking to the future. It forces you to take off the rose-colored glasses and realistically look into your crystal ball.
Although it probably feels like the time is right when you don’t need the loan (and you could be right), don’t despair. Benjamin Disraeli, a British politician, writer, and aristocrat of the nineteenth century, said, “The secret of success in life is for a man to be ready for his opportunity when it comes.” In other words, be prepared for your visit with the banker.
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