Seeking a loan is a natural part of starting or improving a small business. But before an entrepreneur starts talking interest rates and terms, there are many things to get in order first. Here’s a look at several potential problems that can take a toll on the loan process, and ways to avoid them.
Depending on Credit Cards
It may be tempting to get a credit card with a large limit to take care of startup or expansion costs. It’s fast and easy, and having the card in hand means you don’t have to ask anyone else for the funds. But relying on (and maxing out) credit can lead to significant financial issues, both short- and long-term. Here’s how Joshua Sophy describes it in a story for Smallbiztrends.com.
“Maxing out your credit limit is a bad idea if you hope to continue to get business financing,” Sophy says. “Piling up big expenses on your personal or business credit cards only leads to high interest payments. And not being able to pay back your credit card bills will only serve to damage your personal and business credit score. That’s going to make it very difficult to ever find a real loan.”
Lack of Cash
A small business’ cash situation will be an important part of any lending process. Without a healthy cash flow, a loan may be doomed from the start, as Elizabeth Palermo writes for Business News Daily.
“Insufficient cash flow is a flaw that even most alternative lenders can’t afford to overlook,” Palermo writes. “Cash flow – a measure of how much cash you have on hand to pay back a loan – is usually the first thing lenders look at when gauging the health of your business. Therefore, it’s also the first thing business owners should look at when determining if they can afford a loan.”
Hidden Fees
Just as you often hear about contracts, it’s important to read the small print when dealing with a loan. Origination fees, application fees, contract fees – these can all seem minor, but it’s wise to look closer, as Eyal Lifshitz writes for Entrepreneur.com.
“Many lenders charge origination fees of 3-4 percent, which are deducted from the loan amount,” Lifshitz writes. “Depending on how quickly you pay that loan back, that fee can have a large impact on the true interest rate you’re paying. A $30 fee on a $1,000 loan is really a 3 percent fee upfront that will significantly skew your real APR, especially for short-term loans. It’s very similar to ATM fees that seem like a small amount, but can cost you big over the long-run.”
Avoid the Wrong Loan
A small business owner will need to have definite plans for a loan, to avoid misusing the funds. Catherine Clifford describes credit “intended for a short period of time for a long-term purchase, or vice versa” in a story for Entrepreneur.com. It features Michael Toth, a senior vice president at Keybank.
“They will use the wrong type of credit product for the wrong type of purpose,” says Toth. “For example, if you buy a piece of machinery with a loan that was intended to fill a short-term need like employee payroll, then you risk being saddled with a loan that you can’t get out from under.”
Bargain Shopping
When you make a major purchase in your personal life, you don’t stop looking after getting one price. It’s the same for small business owners. Different lenders will likely offer different options, so shop around, Sophy writes.
“Shopping around gives you the opportunity to compare available offers,” says Sophy. “Who’s offering the most competitive interest rate? Who has the best terms? There are more lenders available to small businesses these days, and not all are created equal. Failing to shop around is doing your small business a disservice.”
Be Specific
Lenders naturally want to know how the funds will be used, and that the loan will not go toward frivolous things. Debra Carpenter describes this in a story for The Huffington Post, noting that clarity is essential in the lending process.
“Before you even start to seek out a cash injection, make sure you spend time analyzing if your company really does need additional money, and if so, what exactly the funds would be spent on,” Carpenter says. “Lending organizations want to see that an entrepreneur plans to spend money on the ‘right things’ – that is, on financing purchases or operations that will impact the business in a positive way and help the company to grow. Show lenders that your reasoning is sound by explaining what additional funds will be used for, and the beneficial reasons behind the spending.”
Interest Confusion
Even when a small business owner is paying attention to each detail and number, there may still be confusion when it comes to interest. As Lifshitz explains, the “real” interest rate over a certain amount of time is not often understood.
“For example, if you borrow $1,000 and pay $1,100 back over three months on weekly installments, your interest rate wasn’t 10 percent, as simple math would dictate,” Lifshitz writes. “Taking a closer look at the timeframe for the note and your average principal outstanding reveals that it’s actually closer to 80 percent. … This mistake happens because most businesses simply calculate APR as total fees divided by the amount borrowed, rather than calculating the interest based on the amount outstanding at every point in time (i.e. the amortized amount). The difference is massive for small businesses as financing mistakes are compounded.”
Faulty Bookkeeping
Keeping accurate financial records is a wise business approach in general. It also pays dividends when seeking a small business loan. As Sophy writes in his Smallbiztrends.com piece, accounting matters often get put on the back burner.
“This leads to keeping slipshod records riddled with inaccuracies,” he explains. “It’s hard to go into a bank seeking a loan if you don’t even know the true financial status of your company. If accounting is becoming too much of a chore, check out one of the newer cloud-based accounting apps that integrate with a lot of other tools you may already be using at your company. If you can’t keep your current funds in order, your lender could have serious doubts about giving you more.”
Payback Planning
Small business owners should be well prepared to describe the collateral on hand, as well as having a plan on how to pay back the loan. Without that crucial information, a lender will have more reason to say no, as Clifford explains in her Entrepreneur.com piece.
“A banker won’t approve a loan that he doesn’t think has a chance of getting paid back,” he writes. “So be sure to detail in your business plan how you are going to make the revenue to pay the loan back or any collateral you have to back it up. Also, be sure to explain why the loan is critical for your business.”
