The Most Common Small Business Loan Terms You Need to Know
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If you’re just starting your own business, you may not be familiar with some of the terms used in day-to-day accounting, financing and other necessary back-end operations that keep your business running smoothly. Here are some of the most common terms you may come across, and what you need to know about each.
1. Debt service coverage ratio
Debt service coverage ratio (DSCR) is a way of measuring a company’s available cash flow to pay current debt obligations. The DSCR formula looks like this:
net operating income / total debt = DSCR
Lenders will look at the borrower’s DSCR to determine the likelihood or their ability to repay a loan. It tells lenders if there’s enough available cash flow to cover the new debt payments. Not all lenders use the same exact formula, but most of them use EBITDA (earnings before interest, taxes, depreciation and amortization) to determine net operating income, or a company’s revenue minus its operating expenses, not including taxes and interest payments. You’ll want to aim for a DSCR of 1.2 or better. Here’s an example of what the process might look like:
Step 1: Determine company EBITDA
Annual net income ($120,000) + taxes ($20,000), interest payments ($10,000), amortization ($5,000) and depreciation ($2,000) = EBITDA ($157,000)
Step 2: Determine debt payments
Annual debt payment on business loan (with interest) = $50,000
Step 3: Divide operating income by annual debt payments
$157,000 / $50,000 = 3.14
2. Factor rate
The factor rate, also known as a buy rate, is specific to business lending and is often associated with high-risk loan products, like a merchant cash advance (MCA) or short-term business loan. Factor rates aren’t percentages and are determined by a decimal figure that usually falls between 1.1 and 1.5. The factor rate a lender charges depends on the industry, time in business, business sales and growth, average monthly credit card sales and the business’s credit history.
3. Merchant cash advance
You can’t talk about factor rates and not mention MCAs since most people become familiar with the former through the latter. Merchant chase advances aren’t loans; lenders advance borrowers’ funds in exchange for a percentage of their future receivables. In other words, they repay the lender a daily amount based on their sales. The total amount that’s repaid increases and decreases, depending on that company’s sales, which may not be ideal for some businesses.
4. Equipment financing
Equipment financing is a type of funding that lenders extend to businesses looking to acquire assets, usually equipment, for growth or expansion. Lenders can finance up to 100 percent of the new or old equipment and have the option to use the equipment as collateral against the loan.
It typically makes more sense to buy than lease equipment if you need it long-term, will receive significant tax deductions or can use the equipment for many jobs or projects. Commercial vehicles, restaurant appliances and computer hardware and software are a few examples of equipment that can be financed.
5. Invoice financing
Invoice financing, also known as receivables financing, allows businesses to borrow money against the amounts still owed to them by customers. Invoice financing can help businesses maintain operations while waiting for repayment from unpaid invoices or balances. It’s a form of low-risk, short-term financing where the invoices act as collateral for the small business loan or financing.
6. Interest rate
The interest rate is the amount that a lender will charge to borrow funds. The interest is what they will make from the loan. The loan amount, loan term (in years or months) and annual interest rate are used to calculate your monthly loan payments.
Here’s a simple interest formula you can use to find out how much interest you will pay on a loan.
First, start with the simple interest formula A = P (1 + rt)
A= total accrued amount
P = the principal or borrowed amount
R = interest rate
T = loan term
Here’s how you’d calculate the interest on a $30,000 loan that has a 6.5% interest rate and a loan term of five years:
A = P (1 + rt)
A = $30,000 × (1 + (0.065 × 5))
A = $30,000 × 1.325
A = $39,750
To find the Interest rate, subtract the principal amount from the accrued amount:
I = A – P
I = $39,750 – $30,000 = $9,750
In the above example, the interest rate is 6.5% annually, which will cost a total of $9,750 to borrow $30,000. Several personal finance and small business finance sites have a loan and interest calculator that can help you compute your monthly payments.
7. Prepayment penalty
A prepayment penalty is the amount a business is charged when it pays off its loan sooner than the agreed upon timeframe. If your loan includes a prepayment penalty clause then you could be charged a percentage of the loan’s remaining balance. The Small Business Administration (SBA), for example, charges a prepayment penalty on 7(a) loans with loan terms of 15 years or more if they are prepaid in the first three years. Many short-term loans and MCAs also penalize for prepayment. Be sure to read the fine print and ask your lender lots of questions to avoid unnecessary fees.
APR stands for annual percentage rate. The APR is the annual rate that a lender charges you for borrowing funds. It can be a fixed rate, meaning it never changes, or it can be a variable rate that changes with the market. It is expressed as a percentage to represent the annual cost of funds over the duration of the loan term. APR is made up of any fees or extra costs associated with the loan, except compounding interest.
Revenue is the amount of money a company receives in a given period of time. Revenue is determined by calculating the price of goods or services sold by the total number of units sold. This figure is used to determine net income by subtracting costs from revenue. Revenue is very important when analyzing the financial health of a business.
A business experiences a profit when it makes money after accounting for all of its expenses, including taxes and other costs needed for its viability. A business makes a profit when the amount of revenue exceeds the amount of expenses, costs and taxes.
11. Origination fee
This is a fee, often upfront, that lenders charge you to cover the costs associated with processing your loan. It’s one of the main ways lenders make money for providing their services. Origination fees generally range from 1 to 5 percent of the borrowed amount.
12. Line of credit
A business line of credit allows business owners to withdraw money from a set amount when they need it instead of receiving an upfront lump sum. Borrowers aren’t charged interest or required to make any payments until they actually draw from the line of credit. Lines of credit can be secured or unsecured and you aren’t required to use the full amount of available funds.
13. Term loan
A term loan is a loan that’s generally dispersed in one lump sum and has to be repaid within a specific term period. Many lenders offer long-term and short-term loans. Traditional term loans are best for businesses that have long-term financial needs, while a short-term loan is best for those that need temporary funding and support.
14. Personal guarantee
A personal guarantee is a legal promise by a borrower to repay the loan according to the agreed upon terms. Providing a personal guarantee means you are personally liable to repay that debt even if your business fails or loses revenue. That’s one reason SBA loans are so popular because a portion of the loan is guaranteed by the SBA, limiting the lender’s risk.
Collateral is an asset that’s used to secure a loan, which can be in the form of cash, equipment, property and even future invoices. Collateral-backed loans often come with lower interest rates because there’s less risk to lenders since they can claim the collateral in the event of loan default. In order for a loan to be considered secure, the collateral must meet or exceed the remaining balance on the loan.
16. Secured business loan
A secured business loan is a loan that’s backed by collateral in the form of equipment, cash, property, inventory or future invoices. If the borrower defaults on a secured loan, the lender can legally obtain the collateral, called a lien. Secured business loans minimize the risk to lenders, but also give borrowers with less-than-stellar credit a shot at securing financing.
17. Unsecured business loan
Unsecured business loans are loan products that don’t require collateral to obtain financing. An unsecured loan is the exact opposite of a secured business loan, which means it’s considered more high-risk and usually comes with higher interest rates. Unsecured loans allow you to borrow more money without risking any assets.
18. Profit and loss statement
A profit and loss (P&L) statement, also known as an income statement, reports a company’s financial performance over a specific time period. It provides details about a company’s performance over time rather than at a particular moment. Lenders may request to see your P&L statement when they’re assessing your business’s financial status and to determine whether you can repay the loan.