Business Loan Do’s and Don’ts

When you’re starting a business, it can seem like there are a million and one things to think about.

Top of mind for most entrepreneurs? How to finance their business.

A business loan can be a great source of capital, but it can be difficult to navigate the myriad of loan options available to business owners. Conventional bank loans, online working capital loans, and peer-to-peer loans are just a few of the types of loans that businesses are eligible for.

Fortunately, to make things easier on you, there are certain factors to look out for to make sure you’re getting the right kind of loan and aren’t overpaying. In this article, we’ll give you five pointers to keep in mind when searching for a business loan.

1. Limit the number of loans you apply for

When you’re just starting out in your search for a business loan, it can be tempting to apply for as many loans as possible in the hopes that something will stick. However, such an approach can hurt your credit score, making it harder to qualify for a loan.

Every time you apply for a business loan, the lender will check your credit. In some cases, such as when getting an initial quote, the lender will do a soft credit pull, which won’t affect your credit score.

However, when you submit a full application, the lender will do a hard credit pull. This can dent your credit score by a few points for each application. Sometimes, even getting an initial quote can trigger a hard credit pull.

The wisest approach is to first find out different lenders’ qualification criteria and apply strategically for the two or three options that you’re most likely to qualify for. Also, be sure to ask the lender about its credit check policies, so you’re not caught by surprise.

2. Understand the cost of the loan

Lenders describe the cost of a loan in different ways. Some will tell you the interest rate on the loan, and others may tell you the total amount of money you have to pay back. When lenders describe loan cost in different ways, it makes it difficult to compare your loan options.

To make comparison shopping easier, ask the lender to tell you the Annual Percentage Rate (APR) of the loan.

APR, a term you may be familiar with if you’ve bought a home or car, is the total cost of a loan over one year, including fees. The APR of a bank or SBA loan ranges from around six to nine percent. It can be much higher for alternative lenders that provide fast funding and work with lower credit borrowers.

Keep in mind that a low APR loan isn’t necessarily better than a high APR loan. Short-term loans often have high APRs, but since they are paid off quickly, you’re not paying interest for a long time. As a result, the total amount of money that you have to pay back is relatively low.

3. Be wary of prepayment penalties

While on the topic of cost, prepayment penalties can be a trap for an unwary borrower.

A prepayment penalty is a fee that a lender charges if you pay off a loan before the due date. By paying a loan off early, you reduce the amount of interest that the lender earns on the loan, so they charge a penalty. The fee is usually two to three percent of the outstanding balance of the loan, or it can be on a sliding scale, where the earlier you pay, the higher the penalty will be.

Not all loans have prepayment penalties; for example, standard SBA loans don’t have prepayment penalties. When shopping for a loan, you may also be able to negotiate the removal or reduction of a prepayment penalty. If not, read the fine print before signing the loan agreement so you understand exactly how much you will be charged for prepaying a loan.

4. Choose between a line of credit and a traditional loan

Depending on your business needs, a business line of credit may be a better option than a loan.

A loan is a fixed amount of money that you pay back with interest over a specific period of time; a line of credit is like a credit card. You get approved for a maximum amount of money that you can access as needed, and you repay it over a period of time. The advantage of a line of credit is that you only have to pay interest on the funds you use.

A line of credit is better than a loan in two main cases. If you occasionally need short-term working capital to buy inventory or cover seasonal expenses, a line of credit gives you flexibility. A line of credit also provides a nice safety net to cover unexpected business expenses. Loans typically work better when you need to finance a long-term investment, such as equipment or real estate.

5. Understand which assets are at stake if you can’t pay back the loan

Most lenders will not give a loan to a business (especially a startup) unless it’s secured by collateral, a lien, or a personal guarantee. This shouldn’t be taken lightly. Valuable personal and business assets may be at stake if you don’t pay back the loan, and you should understand what’s on the line.

Loans may be backed by specific collateral (e.g. property, equipment, inventory, and so on) or by a general lien on your business assets. When a loan is backed by specific collateral, you give the lender the right to seize that collateral if you can’t pay back the loan. If a loan is backed by a general lien, then the lender can take any or all business assets to satisfy an unpaid loan.

Even a loan with no collateral or liens may require a personal guarantee. This allows the lender to seize your personal assets, such as your home and car if you’re unable to pay back the loan.

Bottom line

There are a lot of things to consider when you are trying to obtain a business loan, and it can seem overwhelming. Following the five tips above will help you assess the basics of the loan and avoid making a big mistake, like pledging your house as collateral without understanding what that means.

Ultimately, every business is different, and every business needs financing for different reasons. With that in mind, it’s best to ask a trusted advisor and your lender all of your questions before committing to a loan.

A business loan is a big commitment, so you’ll want to cover your bases and make sure you know exactly what you’re getting and what you’re paying for it.