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Overview
You may need additional capital for various reasons such as:
starting or expanding your business, purchasing or refinancing
equipment or restructuring your balance sheet. A loan provides
probably the most flexible solution to meet your financial
needs (but not always the cheapest way to get cash. Depending
on your situation asset
finance/leasing or factoring
might present you with a better option.) A loan is an agreement
in which a lender (finance company/banks) gives money (principal)
to a borrower, and the borrower agrees to repay the money
with interest, at some future point(s) in time. Loans are
very flexible and can be structured to meet your needs.
When arranging a loan, consider its effects on your cash flow
and assets. This section will give you a general overview.
It does not replace professional advice. You may wish to consult
your accounting and tax advisors before finalising a loan
to reap the maximum benefit and avoid complications.
How It Works
Loans may be structured several different ways but the two most
important aspects to consider are the interest rate (type
and method) and the repayment schedule for the loan.
There are two options to set your interest rate:
- Fixed Rate: With a fixed rate the interest rate
(i.e. the percentage) applied to the outstanding principal
remains constant through out a predetermined period that
may or may not equal the length of your loan. The interest
rate is set at the beginning of your loan by examining
the risk involved and the current market rates. The advantage
of a fixed rate loan is that your interest rate is fixed
and the payments constant and they will not rise if the
market rate rises. The disadvantage is that you will
not benefit from a decline of the market rate.
- Variable Interest Rate: With a variable interest
rate the interest rate applied on the outstanding principal
amount fluctuates in line with changes to the Bank Base
Rate or LIBOR and, as a result, so will the amount of
your payments. The interest rate for each period will
be the current market rate plus a predetermined premium
that remains constant throughout the life of your loan.
The advantage of a variable interest rate loan is that
you save money when the market rate decreases. The disadvantage
is that you are not protected from an increase in the
market rate and the interest you pay will increase with
the market rate.
When deciding on your repayment schedule you should always remember
the longer you take to payback the principal the higher your total
interest payment will become:
- "Equal" Payments: This type of loan requires you
to pay the same amount each period (monthly or quarterly)
for a specified number of periods. Part of each payment
goes toward interest and the rest goes toward principal.
After the specified number of periods you will have paid
back the entire loan plus all interest.
- "Equal" Payment and a Final Balloon Payment: This
type of loan requires you to make equal monthly payments
of principal and interest for a relatively short period
of time. After you make the last instalment payment,
you must pay the balance in one payment, called a balloon
payment. Some lenders will give you the option to refinance
the loan to help you stretch out the final balloon payment.
This type of loan offers definite benefits to you. Because
of the lower monthly payments during the course of the
loan, you can keep more cash available for other needs.
Of course, when you are thinking about those nice low
payments, don't forget the big balloon payment waiting
around the corner.
- Interest-Only Payments and a Final Balloon Payment:
With this type of loan, your regular payments cover only
interest. The principal stays the same. At the end of
the loan term, you must make a balloon payment to cover
the entire principal and any remaining interest. The
obvious advantages of this arrangement are the low periodic
payments. But over the long term, you will pay more interest
because you are borrowing the principal for a longer
time.
- Single Payment of Principal and Interest: If your
lender agrees, you can promise to pay off the loan all
at once at a specified date. This payment includes the
entire principal amount and the accrued interest. Borrowing
money on these terms is best for a short-term loan.
- Equal Principal Payments: This type of loan requires
you to pay the same amount of principal each period for
a specified number of periods. The total payment for
each period will be variable (and should decline) as
you pay interest only on the outstanding principal at
the beginning of the period. Borrowing money on these
terms requires larger payments in the beginning of the
loan.
Advantages
- Retain Ownership. Instead of raising funds by selling
an interest in your company to an investor, you retain
the current ownership of your company. The lender is
only entitled to an interest return on its loan, not
a percentage of the profits or a share in the company
that an investor would expect.
- Financial Flexibility. The proceeds from the loan
can be used for almost any purpose including paying off
current debt to avoid higher interest rates, short repayment
term, or pending balloon payment. A loan also allows
you to preserve your cash and working capital.
- Better Cash Flow. A loan gives you access to capital
with minimal up-front payments and the flexibility to
design a loan schedule that suits your needs. You can
organize your loan schedule to match your payments with
the projected cash flows from the proceeds of the funds
this will help you minimise the drain on your working
capital.
- Borrower is legal owner of equipment. If you decided
to take a loan against your equipment, unlike some other
forms of financing you remain the legal owner of the
equipment.
- Maximize Financial Leverage. Normally you can use
your refinance most of your assets, real estate, commercial
equipment and vehicles, to arrange for a loan and may
free up cash flow for other pressing needs.
- Simplified cash flow management. Loan schedules
are preset, making cash management more predictable.
- Tax advantage. Interest payments on your loan are
tax deductible and are made with pre-tax money. Purchases
financed with profits, in contrast, are made with after-tax
money.
Disadvantages
- Additional guarantees. Depending on the credit
rating of your company, the lender might require additional
guarantees. These may be provided by you, your partners
or your bank and could affect your personal credit rating
or your standing with your bank.
- Collateral. The lender may insist on a pledge of
some asset to secure the loan. Under a security agreement
(for personal property), if you default on the loan,
the lender is able to foreclose upon the asset and sell
it to repay the money owed to the lender. If you are
required to provide security, try to limit the amount
you have to give to secure the loan. And make sure that
when the loan is repaid, the lender is obligated to release
its mortgage or security interest and is required to
make any government filings acknowledging this release.
- Defaults. The lender may define a variety of events
that will constitute a default on the loan, including
failure to make any payment on time, bankruptcy, insolvency
and breaches of any obligations in the loan documents.
Try to negotiate advance written notice of any alleged
default, with a reasonable amount of time to cure the
default.
Things to Watch
out for
(see also Disadvantages)
- Loan fees. The lender may charge up-front loan
or processing fees. Check these fees carefully, and try
to get an estimate as soon as possible to help you evaluate
the loan package.
- Prepayment. Ideally, you want to be free to pay
off the loan (all or in part) at any time before its
due date. Unfortunately the majority of lenders are likely
to charge a redemption penalty in the first 3 to 5 years
of the loan. But after that initial period, you should
make sure that your loan agreement gives you this flexibility
and try to avoid a prepayment penalty for paying off
the loan or part of the loan early.
- Grace period. Try to get a grace period for any
payments. For example, the monthly payments may come
due on the first day of each month, but they won't be
deemed late until the fifth day of the month.
- Late charge. If the loan includes a fee for late
payment, try to make sure that it is a reasonable charge.
- Legal Fees. If the lender requires some form of
security, you may incur legal fees arranging for the
appropriate documentation.
- Solicitors' fees. The lender will likely insist
on a clause that says in the event of any failure to
pay on the loan, the borrower will reimburse the lender's
fees and costs in enforcing or collecting on the loan.
Try to insert a qualifier that the reimbursement will
cover only "reasonable" solicitors' fees.
Frequently Asked Questions
(FAQs)
What is the usual length of a loan?
Loans are typically available for any time period between 1 to
15 years.
Why take a loan when I meet my needs with cash?
A loan preserves cash and liquidity. You might be able to secure
better conditions on your loan when you are not in dire need for
cash. A loan can also provide a over cash.
How does my personal credit history affect my chance
of getting a commercial loan?
Lenders use your personal credit history to help them decide whether
you are a good risk for a loan (especially in the case of sole
traders and partnerships). If your history includes late payments
or bankruptcies, you should include a letter with your application
explaining the circumstances and how they have changed. This can
soften the impact of these black marks against you. Always be honest
about your credit history - covering up problems is the fastest
way to get shown the door.
How can I improve my chances of getting a loan?
Be prepared to demonstrate why you have a solid chance of repaying
the loan. It will be extremely beneficial to be able to show the
lender a history of your earnings and a projection of future earnings.
It is also beneficial to show that you have invested in your business,
the lender will more comfortable knowing that your interest are
aligned with its.
Who is responsible for the repayment of the loan?
The legal structure of your company will determine who is responsible
for the repayment of the loan and who will be liable if it is not
repaid. If you are a sole trader, you bear all the responsibility
and potential liability. If your have formed a partnership, all
of the partners involved are jointly and individually responsible.
If you a legal company, the Directors may be liable if the loan
is not repaid.
Glossary
Asset - Any item of economic value owned
by you or your corporation, especially that which could be
converted to cash.
Bank Base Rate - The minimum interest
rate that the bank will charge you for your loan.
Fixed Rate - The interest rate (i.e.
the percentage) applied to the outstanding principal remains
constant through out the life of the loan.
Lender - A financial entity that makes
funds available to others to borrow.
Loan Commitment - A formal offer by
a lender making explicit the terms under which it agrees to
lend the money to a borrower over a certain period of time.
Loan Schedule - A listing of the amount
of principal and interest, due dates and balance after payment
for a given loan.
LIBOR - London Inter-Bank Offer Rate
is the interest rate that the largest international banks
charge each other for loans.
Outstanding Principal - The amount borrowed
from the lender which, at a point in time, remains unpaid
(this excludes interest outstanding).
Principal - The amount borrowed from
the lender.
Secured - A loan that is backed by the
offering of an asset to the lender.
Terms - The specific condition and details
of an agreement or contract.
Unsecured - A loan in which has no assets
backing the loan.
Variable Rate - The interest rate (i.e.
the percentage) applied on the outstanding principal amount
fluctuates from period to period.
Working Capital - The amount of funds
in the business required to finance the day-to-day operations
of the business.
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