Before seeking a business loan, it’s essential to know and understand the terms your lender will use throughout the application process.
For those taking a business loan for the first time, the amount of paperwork needed can feel overwhelming. It can feel dizzying when you sit with a lender for the initial meeting. You’ll likely hear all sorts of terms. These could be terms such as equity, collateral, APR, origination fee, fixed-rate, variable-rate, covenants, and prepayment penalty.
Understanding the eight most essential terms listed below will prevent any surprises after you’ve signed and secured a loan. Plus, it will allow you to make financially-wise decisions before making a final commitment.
1. Equity
Equity is simply the number of your assets after all liabilities have been deducted. If you bought a house for $100,000 and you’ve made $30,000 in payments, your equity is $30,000. When taking out a business loan, it creates a liability, hence, decreases the stake.
Equity financing is the term used when you sell a part of your business to an investor in exchange for capital. For example, you might ask a friend or family member to invest $10,000 in your business venture for 10 percent ownership. The investor now has 10 percent equity in your business.
2. Collateral
Often, lenders require insurance to ensure they will be made whole should you default on the loan. The guarantee becomes security for the loan and is forfeited in the event of default. If you own a towing company and you pledge your tow truck as collateral and default, the tow truck will be repossessed and sold, usually at auction. Should the lender sell the vehicle for more than what you owe, they must remit those funds to you, minus any fees incurred.
3. APR
The APR or Annual percentage rate is the annual interest rate you’re charged for the money you borrow. Of course, you’ll want to shop around for the best fees when considering a business loan. Lending rates may vary quite a bit and can make a significant difference in your monthly payments.
4. Origination fee
Your lender may use the term origination fee. Many financial institutions charge this fee on business loans to defer some of the costs absorbed throughout the application process. For example, the cost of credit evaluation.
The amount charged by lenders can vary, and some lenders will express the origination fee as a dollar amount. Others will reveal it as a percentage of the loan. The amount can be small, or it can be fairly sizable, but some lenders will negotiate the origination fee.
If your loan isn’t approved, you may not have to pay the fee. You should be aware of the origination fee and your repayment obligation before making the application.
5. Fixed-rate
When you take a loan with a fixed rate, it means the interest will remain the same for the duration of the loan. Whatever interest rate you receive will last for the life of the loan, so you won’t need to be concerned about payment fluctuations. Fixed-rate loans are ideal when interest rates are low. If you are someone who wants to know precisely what you’ll be paying each month, a fixed-rate arrangement is what you should seek.
6. Variable-rate
A variable-rate loan is just that. The interest rate fluctuates with the market. This type of loan isn’t ideal for a business as payments are uncertain, and you might not have the revenue needed to meet the amount. Most lenders offer companies a fixed-rate loan to prevent default.
7. Covenants
Some lenders require covenants, which are provisions set in exchange for the loan. Covenants may include requiring you to hold your accounts in their institution or opening your books whenever the lender asks. You want to know upfront what covenants are necessary, if any.
8. Prepayment penalty
Lenders make money from the interest you pay. If you repay a loan early, they lose the unpaid interest. Some lenders ensure they will receive the full amount for the duration of the loan. This point is often in the fine print, so be sure to ask and be clear about any prepayment penalties.
Federal credit unions are prohibited from charging a prepayment penalty, and many offer reasonable rates on business loans.
Know the language your lender speaks. Know what these eight important terms are and use them to equal the playing field. It will make the business loan transaction go much smoother for you, and it will be less stressful to approach a lender when you know what to expect.