Many private businesses use loans or lease financing to help fund their operations. This article provides a brief overview of some key concepts and considerations for potential borrowers.
Application. The first step to obtaining financing is the loan application. In addition to filling out the application, a lender will likely want two- to three-years profit and loss statements or tax returns, according to Greg Oakes, Chief Credit Officer of Cashmere Valley Bank.
A lender requires this information to judge a borrower’s creditworthiness. Often, a financially stronger borrower will get better loan terms, as the lender’s credit risk is reduced. A strong borrower also draws more lender competition, which can further improve a borrower’s loan terms.
Interest rate. Borrowing costs are often a key consideration when deciding whether to borrow. A loan’s interest rate usually impacts these costs the most. In addition to the percentage amount (e.g. 6 percent annual interest), whether the interest rate is fixed or variable could be important.
Variable interest is most often tied to a recognized index, such as the Wall Street Journal Prime Index. As Oakes explains, “a variable rate changes when the index changes and can sometimes include a floor and/or a ceiling. A floor is the lowest the rate can drop. The ceiling is the highest rate of interest a borrower must pay, as the index fluctuates.”
A fixed rate is a constant rate of interest (e.g. 6 percent) until the loan is paid off. A fixed rate protects the borrower against interest rate increases; but can cost a borrower, if the market interest rate drops. Under current tax rules, interest paid on a business loan can be deducted.
Loan fee. Traditionally, a lender may charge a loan fee as a condition to make a business loan. The fee could be about 1 percent of the principal amount loaned. Like interest, the loan fee may be tax deductible. However, these fees are becoming less prominent. You may find a bank, particularly a community bank, will not charge such a fee.
Payment terms. Payment terms dictate how and when the loan will be repaid. Many business loans are repaid over five years, in equal monthly installments. However, the payments could be amortized over a longer term (e.g. a 10 year amortization period), despite full payment due in five years. As Oakes explains, “banks will offer the business owner a term commensurate with the useful life of the equipment or collateral being offered. When the loan is unsecured (permanent working capital) the term will usually be limited to five years.”
Secured or unsecured loan. A loan is deemed secured when the borrower pledges to the lender assets as collateral. This collateral secures the borrower’s promise to repay the loan, per the payment terms. A lender could require collateral. Without it, the borrower may not qualify for the loan. However, not all business loans are secured. Many loans are unsecured, where the lender does not require the borrower to pledge collateral. Per Oakes, unsecured commercial loans are most common with a line of credit for seasonal use to a healthy company with a reasonable net worth and equity in its operating cycle (i.e. the company’s operations are not funded exclusively with debt”).
Personal guaranty. In addition to a pledge of assets, a lender may require the principals of a corporate entity (e.g. a limited liability company or a corporation) to promise to pay the corporate debt, if the corporate entity defaults (e.g. fails to pay). This promise is known as a commercial or personal guaranty.
Prepayment. In some cases, a lender may require the borrower pay a prepayment fee, if the borrower pays the loan off early. A lender can require a prepayment fee with real estate loans and certain SBA loans such as the 504 program, according to Oakes. Whether a loan restricts prepayment can influence the decision to borrow, especially if the interest rate is high or the borrower anticipates paying the loan off early.
Maturity date and extensions. The maturity date is the date a loan is due in full. On this date, the borrower must pay all outstanding interest, fees, and principal. Sometimes, a borrower may be unable to make the balloon payment or may want to keep its cash and extend the loan’s payment term. In those cases, the lender may agree to extend the loan term.
A lender is generally under no obligation to extend a loan. If a borrower anticipates wanting an extension, a good practice is contacting the lender early. “However, if the business faces a balloon payment and the business remains healthy and has made all previous payments as agreed, most banks are more than willing to extend additional terms to see the loan to payoff,” according to Oakes. If denied, the borrower could have time to find replacement financing or gather the funds necessary to make the balloon payment.
Default. A default is when a borrower violates the terms of their loan. Often, this is the failure to make a timely payment. It can also include a borrower’s breach of loan covenants, (e.g. failure to provide financial information, keep a certain level of cash in the business, or injury to collateral).
A default can trigger an increase in the interest rate, commonly known as default interest (e.g. from 6 percent to 18 percent interest). Unlike in the consumer contact, a commercial loan is not subject to Washington’s usury law, which limits the amount of interest a lender can charge. The usury rate is currently 12 percent, but this rate does not apply in the context of business loans.
Financing alternative. The above concepts apply to many types of financing. A common form is conventional financing, where a bank loans funds to a borrower for a fixed term at fixed or variable interest. Another type of financing is a line of credit. A credit line is “most often used for seasonal borrowing needs and it will have a resting (paid to zero) requirement for some specified period of time during the term,” said Oakes. In some cases, a borrower will lease finance. Per Oakes, lease financing might be a good option for “companies with limited working capital and liquidity.”
There are also SBA loans. A business can obtain an SBA loan through a bank. The benefit of an SBA loan may be available to a company on terms otherwise unavailable to a business in the marketplace.
Brian Walker represents businesses and individuals in commercial, business and real estate related litigation and transaction from the Wenatchee office of Ogden Murphy Wallace PLLC.