There’s no question the notion that it takes money to make money isn’t lost on small business owners looking for capital to fuel growth or fund other business needs. And, for many business owners, a small business loan is where they find it. Although borrowing capital from traditional sources like the bank is still a challenge, in many ways there are more options available then ever for business owners to access capital—provided you can answer these four questions:
1. Does a loan really make sense for my business?
Although there are many legitimate reasons for borrowing, my take is pretty conservative. Before you borrow you should consider, “Will the loan purpose add value to the business or provide additional profits? Do I have the cash flow to make the loan payments? Will the extra loan burden put my business at risk?” Any time you borrow money (even at a low interest rate) it’s an important decision with associated costs. Stopping to evaluate whether or not a business loan makes financial sense for your business is always a good idea.
2. What will this borrowed capital cost me?
There are many ways to evaluate the cost of a business loan. In my opinion, it’s critical to understand the total cost of the loan—which is the total interest expense plus any fees. You should also consider the size of the periodic payment and the loan duration to determine whether you have sufficient cash flows to cover the loan payback and whether the loan purpose and ROI period match the loan term.
On short-term loans, some lenders also present cost metrics in terms of simple interest (essentially total interest cost divided by the loan amount), cents on each dollar borrowed, or a factor rate. There are also lenders that annualize the interest rate, but disclose their fees separately. APR, the way many longer-term consumer loans like a home mortgage or an auto loan are priced, includes any fees (like an origination fee) into the APR calculation. Especially on shorter-term loans, annualized rates will be high relative to the simple interest rate because the cost of the loan is repaid over the shorter-duration term and then annualized. It is important to note that the total interest expense of a short-term higher annualized rate loan may be less than that of a long-term lower annualized rate loan.
Given the type of credit product and the business need there are a range of pricing metrics that can help you make an informed decision. And it is always critical to understand the total cost of the borrowed capital so that you can match the loan type to the loan purpose. In much the same way nobody would buy a car with a 30-year mortgage (because the total cost of the loan would increase the cost of the car exponentially), some loan types are better suited for one loan purpose over another.
3. What are the fees?
Make sure you understand any fees associated with the loan. Some lenders itemize the fees separately while others fold them into an annualized rate (APR). Regardless of how your lender presents any fees that might be included in your loan, make certain you understand exactly what fees are being added to the interest you’ll pay.
4. Does my potential lender report to the business credit bureaus?
A lender, or merchant cash advance provider, that doesn’t report your good credit history to the credit bureaus isn’t doing anything to help you build a strong business credit profile. While you might be building a strong credit history with that particular lender, you aren’t doing anything to otherwise improve your business profile. This is an important question and should be considered when you are obtaining any type of financing for your business.
These four simple questions will help you determine whether or not a small business loan is right for your situation.