5 Questions Entrepreneurs Need to Ask Before Taking Out a Bank Loan
Grow Your Business, Not Your Inbox
For small businesses, loans are a vital component of the expansion process and during difficult times. Without loans, everything from securing new equipment, renting office space, or acquiring more inventory would be a struggle, if not flat out impossible. The same goes for times of need; Emergency funds might be needed after natural disasters or during times of widespread illness to help keep businesses afloat and ready to rebound.
Before taking the plunge, it’s important to weigh the pros and cons by asking yourself – and your banker – the following five questions.
1. Why am I taking out a loan?
This might seem like a no-brainer but having a clear sense of why you need the money and what you will spend it on is a necessary first step. Small businesses often take out loans to acquire expensive assets such as equipment or commercial real estate, to buy inventory or raw materials, or “to conserve cash supply for unexpected expenses or low revenue cycles,” says Jay Nelson, a business banking relationship manager at U.S. Bank. (The last bucket applies primarily to cyclical business, such as landscapers, which make the majority of their income during a particular season or time of year.)
Another common reason to need a loan is because of some unexpected circumstance like a natural disaster or a health issue impacting a crucial employee, or even an entire staff. Once you have a solid understanding of what you would do with the 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?
When working with clients, 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.
A loan’s terms, which include length of repayment, interest rate, and proposed collateral, should align with the type of expenditure it’s financing. As a rule of thumb, the longer the repayment plan, the greater the risk of default and the higher the interest rate. Therefore “if it’s something you can pay back in a year, your banker should recommend a shorter-term product,” Nelson says.
Credit history and collateral 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.
3. Does my business have a credit history?
A business’s credit history is usually separate from the business owner’s personal credit history, a division entrepreneurs often don’t realize. Nelson has worked with clients who have been in business for several years without taking 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?
If your business has been up and running for less than two years and you don’t have a sufficient credit history, you might consider an SBA loan. Unlike conventional loans, SBA loans are backed by the government and can provide extended terms for the business to repay the debt.
SBA loans are often 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 from a management standpoint for a SBA loan approval. However, since the purchase price of the business was more than the business assets that may be available for collateral to support the loan, the loan would be under collateralized.
5. What is the true cost of the loan, and how am I going to repay it?
Before taking out a loan, make sure you understand its true cost. 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.” Such a 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, at heart, conservative people who are nonetheless 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.
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.
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