How to choose a business loan: 5 factors to consider
When shopping for a business loan, many entrepreneurs make the mistake of focusing solely on the interest rate at the expense of other factors.
While the interest rate is important when choosing a business loan, it’s not the whole story. You should be wary of surrendering too much control and flexibility for the sake of a few percentage points on an interest rate. Otherwise, any kind of setback may leave your business, and whatever assets you had to offer as collateral to secure that lower rate, at risk.
Shop around to understand what’s available
Different banks offer different loan products. Key differences are often buried in the fine print. Look for the following information.
- What types of loans do different banks offer?
- What are the loan authorization policies and procedures? Who will authorize your loan?
- Are there specialized account managers for your type of loan or business? These individuals can sometimes better appreciate and understand your business.
- Is your account manager willing to negotiate with you? For example, could you get lower fees and more flexibility on repayment terms?
Don’t just take a bank’s word for it. Tap into your network of business contacts. Ask them about their experience with a given bank, the quality of service, any problems they may have had, what was and wasn’t negotiable, and what the bank looked for in a loan proposal.
Before committing to a lender, you should consider the following five factors.
1. Loan term
How long a loan term is the lender willing to offer?
Longer terms mean higher borrowing costs, but that may be an expense you want to incur to ensure you don’t run into cash flow problems.
2. Loan size
What percentage of your project’s cost is your lender willing to finance?
This will determine how big an investment you must make and whether it makes sense to diversify your lending relationship with a second bank.
What is the lender’s flexibility on repayments?
As a business person, you know even the best plans can go awry due to unforeseen developments. It’s important to have a frank discussion with your banker about what would happen if you found yourself unable to make scheduled loan repayments. Would your bank let you temporarily suspend principal repayments, for example? It’s important to find out ahead of time, not during a crisis.
What guarantees are being requested of you in case of default?
If you default on your loan, the bank can go to court to obtain the right to sell the collateral. This is always a last resort, because everyone loses in the process.
Collaterals can include your accounts receivable, pledges and liens (equipment and other fixed assets), inventory, real estate, personal guarantees and third-party guarantees. The type of collateral you offer depends on the nature of your business, the terms and conditions of the bank and the leeway you have to negotiate.
You should know what assets you risk losing in case of a default. This risk may extend beyond your business to include personal assets.
5. Financial reporting and covenants
What reporting and financial obligations is the bank requiring?
Most loan terms have financial reporting obligations requiring that financial statements and reports must be provided to the bank on an annual basis. Smaller loans typically have less demanding reporting requirements.
A covenant is an agreement between the bank and the borrower by which the borrower agrees to a series of conditions in order to get a loan. If a covenant is broken, the terms of the loan are breached and the bank could demand the entire loan be paid back.
For example, as part of a covenant, you might agree not to take out further loans or to maintain a certain financial ratio at a specific level.
Protecting your everyday cash
It’s important to negotiate a loan that fits your needs and those of your company. That’s why you should carefully consider when to borrow, how much to borrow and how fast you want to pay back your loan.
Many of these considerations have to do with protecting your company’s everyday cash—ensuring you can continue to fund the day-to-day operations of your company.
For more tips, download your free copy of our guide How to Get a Business Loan: A Guide to Preparing a Winning Loan Request