Financing Options

Terms

The period for which a bank loan is issued is called its maturity. A short-term loan is for less than a year, an intermediate loan for one to five years, and a long-term loan for five years or more. Banks can also issue lines of credit that allow you to borrow up to a specified amount as the need arises (it's a lot like the limit on your credit card).

In taking out a loan, you want to match its term with its purpose. If, for example, you're borrowing money to buy a truck that you plan to use for five years, you'd request a five-year loan. On the other hand, if you're financing a piece of equipment that you'll use for ten years, you'll want a ten-year loan. For short-term needs, like buying inventory, you may request a one-year loan.

With any loan, however, you must consider the ability of the business to repay it. If you expect to lose money for the first year, you obviously won't be able to repay a one-year loan on time. You'd be better off with intermediate or long-term financing. Finally, you need to consider amortization - the schedule by which you'll reduce the balance of your debt. Will you be making periodic payments on both principal and interest over the life of the loan (for example, monthly or quarterly), or will the entire amount (including interest) be due at the end of the loan period?

Security

A bank won't lend you money unless it thinks that your business can generate sufficient funds to pay it back. Often, however, the bank takes an added precaution by asking you for security - business or personal assets, called collateral, that you pledge in order to guarantee repayment. You may have to secure the loan with company assets, such as inventory or accounts receivable, or even with personal assets. (Likewise, if you're an individual getting a car loan, the bank will accept the automobile as security.) In any case, the principle is pretty simple: if you don't pay the loan when it's due, the bank can take possession of the collateral, sell it, and keep the proceeds to cover the loan. If you don't have to put up collateral, you're getting an unsecured loan, but because of the inherent risk entailed by new business ventures, banks don't often make such loans.

Interest

Interest is the cost of using someone else's money. The rate of interest charged on a loan varies with several factors - the general level of interest rates, the size of the loan, the quality of the collateral, and the debt-paying ability of the borrower. For smaller, riskier loans, it can be as much as 6 to 8 percentage points above the prime rate - the rate that banks charge their most creditworthy borrowers. It's currently around 3 percent per year.