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3 Steps When Choosing a Type of Business Loan

As a small business owner, you know that debt  is not a solution to business challenges—it is a tool that can be used to increase your profitability or manage your cash flow, but it can work against you if not used appropriately and prudently.
If you’ve made the decision to borrow in order to finance your business goals, you may be wondering where to start. Deciding which type of loan to use can be confusing. Let’s face it: some of the lenders in today’s market will try to mislead you on what they offer.
Here’s what you need to know in order to make the right decision for your business:
  1. Determine how much you need to borrow. It’s important to look at how debt can amplify returns on your business investments. Business owners who have the utmost confidence in an investment should feel comfortable using debt to provide the required capital for that investment. If, on the other hand, your business investment is highly speculative, consider using only a small loan to fund your initiative.
  2. Remember the Basic Rule of Thumb. Corporate finance theory tells you to use short-term debt for short-term investments (such as turning over inventory), and long-term debt for investments with a longer payback period. We totally agree with this philosophy. Business owners approaching today’s financing market should tread cautiously because there are some lenders out there who are marketing short-term financing options as a tool for long-term investments. For example, a loan that requires daily payments over 6-12 months for repayment does not match the payback period for investing in people, equipment, renovations, new product lines, new facilities, new technology or other longer-term investments . Those types of investments typically take a year or more to achieve their true financial value. Be sure to use a loan that matches your company’s investment horizon.
  3. Know what your options are.  First, let’s assume that you do not have real estate to use as collateral. If you do have commercial real estate available to use as collateral for accessing a loan, it is most often the cheapest way to go; this method provides very attractive payback periods since real estate is very high quality collateral. Plus, banks are generally quite good at lending against real estate.
 

Breakdown of Financing Instruments

For businesses that do not have real estate as collateral, here is a breakdown of the financing instruments for the three main types of business loans:
 
Short-Term (1 Year or Less)
  • Bank Line of Credit
  • Accounts Receivable Financing
  • Merchant Cash Advance & Other Daily Payment Products
Think of these as liquidity tools, not loans. These options offer you the ability to manage unpredictable short-term cash flow, short-term mismatches between your payables and your receivables, and small inventory turns. 
Within this category, a bank line of credit is without a doubt the most appealing and cost effective. However, it is also the hardest to access given bank underwriting standards.
On the other end of the spectrum are merchant cash advance facilities and other daily payment products. These products are often quoted on an advance rate of about $1.20 on the $1.00. This is different from an interest rate. What this means is that once they hand you $1.00, you owe them $1.20 no matter what. If you called them back the next day and said you were ready to pay them back, they would ask you for $1.20. What’s more, given that the contractual repayment period is often 9 months or fewer, the effective Annual Percentage Rate can be a whopping 40%-150%! 
 
Long-Term (1–5 Years)
  • Term Loans
  • Equipment Leases
 
The two main long-term financing options are equipment leases and term loans. There is a major difference between equipment leases and term loans—collateral. A lot of financing providers out there are willing to lend against collateral, so you can expect that financing will be available for almost any piece of equipment you are buying. The important thing to keep in mind with equipment leases is the structure of these contracts. Once you sign a lease, you may be contractually obligated to make the full payment stream to the leasing company, even when you pay off early.
Term loans are designed for companies looking to make investments that will expand their business, such as hiring more employees, initiating marketing campaigns, making large inventory purchases, renovating facilities and more. What you need to keep in mind is that term loan providers (like Fundation) do not require specific collateral (but typically do require a personal guaranty and a blanket lien on all business assets). Because most businesses do not have specific collateral to pledge against a loan, term loans can be very attractive financing tools given their rates and longer repayment periods (2+ years).
 
Very Long-Term (7+ Years)
  • SBA Guaranteed Loans
 
Government programs (like the SBA guaranteed loans) are currently the only loans that permit longer than 5 years for repayment.
 
What We Recommend
We believe that term loans are the smartest way to borrow money for your business. Term loans will allow your company to make an investment, with longer repayment terms and lower rates in comparison to the other products on the market. Even better, you can prepay without penalty. 
 
 
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