Loans are almost always a necessity for new and small businesses. A common misconception about business loans is that they are used for starting a small business, and nothing else. The truth is, besides starting small companies, business loans are needed to maintain cash flow as well. Most businesses have a line-of-credit loan on the back burner for when issues work against plans. This is normal, and the more you know beforehand, the more comfortable you will feel with your lender and borrowing situation. In this article, we will be discussing the three major types, or categories, of loans used by small businesses. We will also be discussing secured loans vs. unsecured loans.
The 3 Types of Loans
The first thing to know is that all lenders have various names that they give their loans. Don’t panic! The point of this article is to provide you with the three most common categories in which these loans fall into. Establishing a good relationship with your bank or lender is key when it comes to borrowing. Once you’ve established a bank, communicate clearly what your business needs are and how their services will best fill those needs.
This is the most common type of loan that small businesses will use to keep cash-flow running smoothly. These loans are designed to cover the cost of inventory and payment of operating costs. The nature of this loan is not to be used for business growth such as real estate, renovations, and equipment but only for stimulating cash-flow. This is a short-term loan. The extent of that loan is up to the discretion of you and your loan officer. The amount in which you receive is generally based on your credit score. Your credit score and previous loan history will also determine the amount of interest charged on that loan. Fortunately, Line-of-Credit loans fall on the lower spectrum of the interest rate scale because they are seen as low-risk loans. Most Line-of-Credit loans are written for one year. During this period, interest rate payments are made monthly, while the payments on the principal are up to the discretion of the business owner. It’s recommended that business owners make principal payments a little each month, rather than waiting until the end of the term to pay it in full.
Installment loans are to meet whatever needs the business owner decides. This would be in place of a Line-of-credit loan, which is designed specifically for operating costs and inventory. Installment loans can essentially be used for whatever the business wants. The way an Installment loan works is that an equal amount is leveled month-to-month for combined principal and interest payments. The loan is in full to the business when everything is signed and set. Interest is determined before the loan is handed out, so if you pay the Installment loan before its end, the interest rate is adjusted. Depending on the nature of the loan, the length of payback time will vary. They can range from a business cycle of 4 months to 1 year to pay off the loan. But if using this loan for real estate or renovations, they can have a payoff of up to 20 years. The shorter the life of the loan, the lower the interest rate you will have to pay.
Balloon loans are received in full on the date that the contract is signed. Interest is paid off on a month-to-month basis with a “balloon payment” of the principal due at the end of the term. These loans typically have lower interest rates and are most commonly used for mortgages. Every bank is going to manage its balloon loans differently. Often banks offer ‘reset’ options for their balloon loans to reset the interest rates and expiration dates based on current interest rates. At the end of the balloon loan term, you have three options: pay it off in cash (and keep the asset), sell the asset, or refinance.
Secured vs. Unsecured Loans
Loans are either going to be secured or unsecured, and this is entirely up to the bank you choose to borrow from. Secured loans simply require collateral if things go sour and unsecured loans do not. Unsecured loans almost always have higher interest rates, given their nature. New businesses with zero financial and success history are usually never going to be given an unsecured loan. These typically follow after a positive relationship has been developed between the lender and the borrower.