Every small business needs capital to succeed and grow. Without cash on hand, you can’t buy the equipment you need, pay your employees, or contract with suppliers to get raw materials and inventory.
One way that small business owners ensure they have the cash they need is by applying for small business loans. In fact, one of the most common questions we hear from our business clients is this:
What features should I be looking for when I evaluate small business loans?
The truth is that not all small business loans are created equal. The features that one lender offers may not be offered by another lender. That said, there are certainly some features that we think are critical. Here are five of the most important features to look for when you apply for a small business loan.
#1: Interest Rates and Compounding
You probably already know that choosing a loan with the lowest possible interest rate is a good idea. Your interest rate will have a direct impact on how much you must repay. However, one issue you may not have considered is how the lender you choose compounds interest on your loan.
Most business loans use some form of compounding, which calculates interest based on the principal of the loan plus accumulated interest. You’ll pay slightly more if the interest is compounded monthly than you would if it were compounded annually. It’s important to know how each lender will compound the interest before you sign on the dotted line.
#2: Loan Term
The next thing to look for is the loan term. Business loans may have short terms (1-3 years) or long terms (5-10 years). You’ll need to evaluate the risks and rewards of the terms before you decide on a lender.
The upside of a long loan is that you’ll have more time to repay the balance and lower monthly payments than you would with a short-term loan. The downside is that, in the long run, you’ll likely pay much more in interest than you would with a shorter term.
Amortization can play an important role in your term. An amortizing loan is where you pay down the principal amount of a loan over the life of the loan, usually with equal monthly payments. These are usually auto loans and mortgages. Businesses can benefit from amortizing loans because they significantly reduce the credit risk and the duration of the debt.
We recommend comparing both monthly payments and total interest before you decide. If your cash flow is unreliable, you may decide that a lengthy term is in your best interest. Remember, you can always refinance your loan in the future if your cash flow improves.
#3: Loan Conditions
Loan conditions can vary greatly from lender to lender. Some of the things to look for include:
- When monthly payments are due
- Penalties for late or missed payments
- Limitations on how you may use the money
- Reporting requirements for expenditures
- Penalties for unauthorized use of funds
The key here is that you want to be confident you understand what your rights and responsibilities are, and that you aren’t surprised by any hidden fees or penalties because you didn’t properly review the contract before signing it.
#4: Type of Loan
Not all business loans are created equal. The most common type of business loan is an installment loan, which works like a mortgage. Every month you pay a fixed amount that is some combination of interest and principal, and the loan is paid in full at the end of the term.
Another option that may work for some business owners is a balloon loan. With a balloon loan, you pay interest only on a monthly basis. The full balance of the loan comes due at the end of the term. If you know you’ll have a lump sum to repay the principal, this option may help you with cash flow during the term of the loan.
More often for commercial mortgages, there will be a structure of principal and interest payments, followed by a final balloon payment as outlined above. For example, a loan with a 10 year term and a 20 year amortization where at the end of 11th year, the final balloon payment would refinance the balance.
A third option is to get a business line of credit instead of a loan. With a line of credit, you withdraw only the amount you need and pay interest only on what you withdraw. If you pay back what you’ve withdrawn, you won’t pay any interest until you make another withdrawal. A line of credit can help you save money on interest if your company can qualify for one.
#5: Support and Service
Finally, you should find out if you’ll have a dedicated account representative to answer questions and help you manage your loan and finances. One way to get the support you need is to get a loan with the same financial institution where you have your business bank account.
Don’t be afraid to ask questions about customer support. It can be frustrating for small business owners to take out loans with big banks, only to discover they can’t get a representative to speak with them about their business needs. That’s one reason you may want to consider getting a small business loan from a local credit union like CFE.
Comparing small business loans can help you choose the best option for your business financing needs. The five features we’ve outlined here are the most important ones to consider in our opinion.
To learn more about CFE’s small business loans and lines of credit, please click here now.