Types of Business Loans, How They Work, and the Best Uses Each Type of Loan
All business loans are not the same. Each type is best suited for a different purpose.
There are a few main types of business loans used by small businesses. In this article, I’ll explain how each of these types of loans works and the best use for each type of loan. You want to match the type of loan with the purpose of the loan. Not doing this can lead to a cash crisis.
Credit cards
I was in banking for many years and know that credit cards, including personal credit cards, are a popular source of business financing. They’re an easy source of financing when someone is hungry for money to fund their business dream.
When an owner uses multiple credit cards, it can seriously hurt their credit score. Just signing up for multiple cards reduces your credit score. If cash gets a little tight and they start missing payments, even bigger damage is inflicted on their credit score. This could prevent them from getting other sources of capital that would be more appropriate for their business. Credit cards have very high interest rates and fees, especially when a payment is missed. This is easily the most expensive loan you can get.
Employees also like to use their personal credit cards for business expenses to earn miles or points. You must balance this with using company cards that give the business better control, reporting, and efficiency.
Business credit cards may be tougher to get than personal credit cards for new businesses. However, business credit cards are a convenient way for companies to make purchases. It may be better to consider them more for their usefulness as a payment method than their appropriateness as a cash flow tool.
Business Lines of Credit (LOC)
Business lines of credit are an excellent business loan choice for short-term cash flow needs.
You usually pay an annual commitment fee based on the commitment amount of the loan. For example, if your commitment amount is $100,000 and you are charged a 1% commitment fee, you would owe $1,000 for the ability to use the line. This fee can be advanced from the line.
Interest is paid monthly based on the sum of the previous month’s daily principal times the daily interest rate. Lines of credit usually have a floating rate, often with the Prime rate as the index.
It may be collateralized by inventory or receivables. Companies that are stronger financially can get unsecured lines because of the strength of their cash flow.
I mentioned earlier that the commitment amount of the loan is the maximum amount you can have in outstanding principal balance at any time. The available balance is the commitment amount less any outstanding principal balance.
When you borrow from the line, it’s called taking an advance or drawing on the line. For example, if you took an advance of $1,000, the principal balance of the line would go up $1,000. That amount would be credited to your deposit account at the bank.
Operationally, you do this as a transfer from the line to your deposit account via the bank’s online banking system. You make payments on the line by transferring money from your checking account to the line. It’s very easy.
Business lines are revolving lines of credit. “Revolving” means you can take multiple advances and make multiple payments. The principal balance can go up and down many times. Your commitment amount always stays the same.
The available balance decreases with each advance and rises with each payment. Let’s say your commitment amount is $100,000. That’s also your available balance until you take an advance. If you take an advance of $1,000, your principal balance is $1,000, your available balance is $99,000, and your commitment amount is still $100,000. If you then make a payment of the $1,000, then your principal balance is zero, and your available balance goes back up to $100,000.
One way lenders ensure that the line is used for short-term needs is by requiring that you periodically rest the line. Resting the lines means paying the principal balance down to zero. Your loan agreement will specify:
- How frequently you must do this
- How long the principal balance must stay at zero before you can take advances again
Lines of credit are for short-term working capital needs like inventory, payables, or payroll. I know the head of a small company that received monthly financial statements. Those financials always showed decent cash balances. He went to write a check in the middle of a month, but there was no cash. The bulk of his revenue was received near the end of the month. His month-end cash balances were fine, but he didn’t realize how tight cash was mid-month. He got a line of credit to fix that.
Lines are also used for longer seasonal needs. I worked at a community bank that served many farmers. They would draw on their operating lines of credit during the growing season and pay the lines off after harvest.
Lines are renewed annually. The lender will check on the financial health of the borrower during the renewal. The borrower will need to submit updated financial statements or tax returns to the bank. For those of you who provide tax, audit, or financial reporting services, your clients will be asking for these reports to give to the bank.
One clause in loan agreements to look for that’s common in lines of credit is the “due upon demand” clause. This clause allows the lender to “call the loan” at any point.
Calling the loan means the lender can demand that the full outstanding balance needs to be immediately paid in full. This may happen if the borrower’s financial situation is worsening. It might also occur when the lender is weak. It’s used very, very rarely, but you want to be aware of it during times of extreme stress in the economy and financial system.
In the movie It’s a Wonderful Life, George Bailey is about to leave on his honeymoon. Ernie, the taxi driver, points out that there is a run on the Bailey Building and Loan that Bailey runs. The panic was sparked when a bank that Bailey Building and Loan worked with called their loan. George’s uncle gave all the cash Bailey Building and Loan had to the bank and closed the building and loan’s doors in panic. George calms the mob and saves the building and loan until his uncle almost ruins it again.
Situations like that were more common during the Great Depression than the Great Recession. What did happen during the Great Recession was that banks reduced the commitment amounts of loans. They did this especially if the borrower never borrowed the maximum commitment amounts. This improved the banks’ regulatory capital ratios.
There’s a joke that a banker is someone willing to lend you their umbrella when it’s sunny but asks for it back when it starts to rain. The “Due Upon Demand” clause and reduced commitment amounts are the realities behind that joke.
Equipment loans
A term loan is a loan where equal principal and interest (P&I) payments are paid on a schedule based on the term of the loan. Equipment loans are term loans with amortization terms of 3-10 years and no balloon term. Equipment loans are usually fixed-rate with consistent P&I payments. They are collateralized by the equipment that’s being purchased with the loan funds.
Commercial Real Estate (CRE)
Commercial real estate loans, called CRE loans for short, may be fixed-rate or variable-rate. They could have different repricing, balloon, and amortization terms.
They are collateralized by commercial real estate. Equipment loans are usually extended when buying equipment. You can get a CRE loan when buying real estate or improving real estate. You may also get a CRE loan when you want longer-term loans and have equity in your commercial real estate to borrow from.
It’s common for businesses to have more than one loan collateralized by the same property. Another thing that can happen is for two pieces of property to be collateralized by the same loan. This is called cross-collateralization. Selling one of those properties (but not the other) while not paying off the loan will require the approval of the lender.
Construction loan
You may take out a construction loan if you are building or improving real estate. Construction loans have a term of one to two years. They are usually floating-rate. Monthly draws or advances are made on the loan to pay the builder based on how much construction has been completed since the last payment. At the end of the construction period, the construction loan is converted or refinanced into a CRE loan discussed earlier.
The Next Steps
Once you know what type of loan you need, the next step is to find a lender. For small businesses, the first question may be whether you should get an SBA loan. I list the pros and cons of SBA loans here.
Another good place to start is with your current bank or credit union. Build a relationship with a business banker long before you need a loan. They can help you be better prepared to get a loan.
Check out my Business Loan Basics course for more insider insights and tips for getting the best loan.
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