It’s no secret that in the small business world, loans are nearly a necessity. This is especially true when it comes to eyeing an expansion and when economic uncertainty arises. Without loans, securing new equipment, renting office space and acquiring more inventory would be a struggle, to say the least. In times of financial hardship, emergency funds may also be needed – such as in the wake of a natural disaster or during an unprecedented event like COVID-19. Loans can be used in a variety of ways to help keep businesses on track.
Before taking the plunge, it’s important to weigh the pros and cons of what it will mean in the short- and long-term for your business. Consider your answers to these five questions before you and your banker get started.
1. Why am I taking out a loan?
It might seem obvious, but having a solid understanding of why you need the money and how you will spend it is always the first step. Small businesses often take out loans in order to purchase expensive assets. These assets might include equipment, commercial real estate, inventory or raw materials. Unexpected circumstances like a natural disaster or a health issue impacting a crucial employee, or even an entire staff, are also reasons to seek a loan.
The loan could also be used “to conserve cash supply for unexpected expenses or low revenue cycles,” says Jay Nelson, a business banking relationship manager at U.S. Bank. (This primarily applies to cyclical business, such as landscapers, which make the majority of their income during a particular season or time of year.)
Once you have a solid understanding of what you would do with the loan money, it’s worth asking whether you’re in a position to pay cash instead of borrowing the funds. “Those are the kind of [questions to ask] right off the bat,” Nelson says.
2. What are the terms I would be agreeing to?
Nelson breaks down business loans into two major categories: long-term expenditures, like real estate, which are typically financed over a significant period of time; and short-term loans, such as those used to purchase a piece of equipment that has an operation life of a few years. Credit history and collateral also affect a loan’s rate: in general, the better your credit history and the more valuable the collateral you put down, the less interest you’ll be required to pay.
A loan’s terms include length of repayment, interest rate, and proposed collateral. These should always align with the type of expenditure it’s financing. In general, the longer the repayment plan, the greater the risk of default and the higher the interest rate. “If it’s something you can pay back in a year, your banker should recommend a shorter-term product,” says Nelson.
3. Does my business have a credit history?
The credit history for a business is typically separate from the business owner’s personal credit history, a division that entrepreneurs don’t always recognize. Nelson has worked with clients who have been in business for several years, but never took out a credit card or loan under their business’s name. Their own personal credit might be exemplary, but “if they come to a traditional bank, not having a credit history for their business could be detrimental,” he says. “Businesses need a credit history.”
4. Is my business a good candidate for a Small Business Administration (SBA) loan?
An SBA loan is a great option to consider if your business has been up and running for less than two years and you don’t have sufficient credit history. Unlike conventional loans, SBA loans are backed by the government and can provide extended terms for the business to repay the debt.
These are also a good option for entrepreneurs who are looking to make an acquisition. Nelson recently worked with a client who was trying to purchase a pharmacy and he recommended an SBA loan. The client had extensive industry experience, which is a plus for an SBA loan approval. However, since the purchase price of the business was more than the business assets that may be available to support the loan, the loan would be under collateralized. Here’s what you’ll need to apply for an SBA loan.
5. What is the true cost of the loan, and how am I going to repay it?
While loans can be helpful, it’s imperative that you’re fully aware of all the costs involved. In addition to interest, loans can include added fees, such as appraisal costs and penalties, which can be incurred for a variety of reasons, like paying off the loan too quickly.
You should also have a solid understanding of how you’ll go about repaying the loan “without it causing a detrimental effect on your business cash flow,” Nelson says. While the bank will do its own cash flow analysis to determine how much debt a company can afford to take on, “the business owner should consider this, too.” This type of calculation requires estimating how much you can realistically pay back on a monthly basis, taking into account how the loan will affect your bottom line. “Will it improve my production level? My revenue stream?” Nelson says. “Will it make my company more efficient?”
Most of the business owners he’s worked with are willing to take calculated risks for the growth – and future health – of their business. But at the end of the day, after consulting with their trusted advisors, it’s up to each individual owner to determine the amount he or she is comfortable borrowing.
Editor’s note: This article was written by our partners at U.S. Bank.
U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.
Credit products are offered by U.S. Bank National Association. Equal Housing Lender. Deposit products are offered by U.S. Bank National Association. Member FDIC.
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