Running a business can be stressful. It can take years before new business owners start to see a return on their investment, and if they don’t have enough working capital to see them through to the breakeven point, they may be forced to close their doors before they ever reach that point.
Often, even with the most carefully prepared business plan, new business owners find themselves facing unanticipated expenses, or sales revenue not growing as fast was expected. Initial working capital secured from personal savings, loans from family and friends, or contributions from angel investors might prove to be insufficient to get the business to its breakeven point.
In those circumstances, taking out a business loan may be the only option, unless the business is showing sufficient potential to attract new equity investors. But more equity investors means diluting control, and that may be a less attractive option to taking out a loan.
Business loans can be categorized into two types: Firstly, the more traditional loans that are sourced from commercial banks or private non-bank lending institutions and repaid over a period time on a fixed schedule; and secondly, a newer type of loan that is called a merchant cash advance that is offered by finance companies like Beyond Merchant Capital, and credit card companies, and automatically repaid through deductions from the business’ credit and debit card sales.
The first type of loan can be secured or unsecured, whilst the second type of loan is unsecured. The advantages and disadvantages of each will be discussed in this article, as well as the different circumstances that a business may find itself in that makes one type of loan more suitable than the other.
A secured loan is one where the applicant offers up a valuable asset as collateral to guarantee that the loan will be repaid. The asset can be a house, an apartment, a commercial property, a car, a boat, a valuable piece of artwork, a set of jewellery, expensive musical instruments, or sometimes even white goods, but most lenders look for a commercial or residential property deed.
By providing the lender with collateral that is worth more than, or close to the amount of the loan, the lender is virtually guaranteed that it won’t lose money on the loan because if the borrower defaults, under the terms of a secured loan agreement, the lender will be able to take possession of the asset and sell it to repay the loan.
Since lenders assume lower risks in this scenario because of the collateral, they can provide loans for longer periods with lower interest rates. This means that the loan repayments can be spread over a longer periods with monthly repayments that can either be fixed in advance, or allowed to fluctuate according to prevailing interest rates.
Generally repayments will be a little higher if the repayments are fixed in advance to cover the possibility of interest rates rising during the period of the loan, but the advantages to the borrower is that they can budget on the basis of those fixed repayments right through until the loan is fully repaid according to bank reconciliation. Taking the fluctuating rates option can sometimes work in the lender’s favor and sometimes in the borrower’s favor.
The best business loan deals are always available from banks on a secured basis, but the downside for the borrower is that if something goes wrong and the business fails, then they will likely lose the asset that was provided as collateral, and they may not receive anything back from the bank’s sale of the asset, because these are often sold at auction for less than their market value.
Therefore secured loans are best for businesses in circumstances where the loan can be applied to a business expansion initiative such as expanding to larger premises, opening new branches, or upgrading equipment that the business owner is confident will result in an increased level of sales and profit that will cover the loan repayments.
This type of business loan doesn’t require borrowers to surrender any asset as collateral. This is why unsecured loans are usually harder to obtain since lenders have to base their decisions using only the information provided by the applicant. An applicant should have a positive credit rating aside from demonstrating that they are running a profitable business. Failure to repay the loan will give the debtor a bad credit rating, making it harder for them to secure loans in the future.
Unsecured loans pose higher risks to lenders and this is the reason they impose higher interest rates. They also provide a lower amount of loanable money compared to secured loans. Many banks, as well as finance companies, offer unsecured business loans although for smaller amounts online lenders are more popular because of their convenience.
For retail businesses that have been averaging at least $10,000 in credit and debit card sales for at least 6-12 months, the easiest option to secure additional working capital for advertising promotions or inventory replenishment are the merchant cash advances. These are repaid by the finance or credit card company taking a small percentage from every card sale made through the point-of-sale terminal.
This means the repayment schedule is tied to the business’ sales volume, so if sales are slow, repayments are less, but when sales are higher, the repayments are higher – and the loan is paid off faster. Thus budgeting can be done on the basis of a fixed percentage of sales being used for the loan repayments rather than a fixed monthly dollar amount as is usually the case with secured business loans.
Unsecured loans will always carry much higher interest rates than secured loans, and therefore sales and cash flow forecasts need to be realistic to ensure that borrowing more capital is not going to place the business under financial strain.
Incurring more debt always carries an element of risk, especially for SMEs who haven’t been in business for many years. Owners should be wary of the amount they borrow, making sure they don’t borrow more than what they are confident of repaying. They should also apply for a loan only when absolutely necessary. Applying too often and getting rejected can negatively impact their credit rating, making it harder to obtain loans in the future.
The type of loan best for any particular type of business depends on several factors and involves weighing up the pros and cons of secured and unsecured loans. Secured loans are easier to get but they’ll require an asset to be offered up as collateral before the loan is approved. Institutions offering unsecured loans, on the other hand, don’t require collateral but loan amounts are usually smaller, and interest rates will be higher which means the loan may take longer to pay off.
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