Loans - The Basics
loan is based on a simple idea: Someone gives you
money, and you promise to pay it back, usually with
interest. The entire risk of your enterprise is
placed on your shoulders. To help keep the risk
low, a lender will very likely ask for security
for the loan -- for example, a mortgage on your
house so that the lender can take and sell your
house if you don't keep up your loan payments.
If you're confident about the future of your business
and you have the opportunity to borrow money, a loan
is a more attractive source of money than getting
it from an equity investor, who will own a piece of
your business and receive a share of the profits.
However, you don't have to repay equity investors
if the business goes under.
case you decide on a loan, here are the basics.
A lender will almost always want you to sign a written
promissory note -- a paper that says, in effect,
"I promise to pay you $XXX plus interest of
XX%" and then describes how and when payments
are to be made. A bank or other commercial lender
will use a form with a bit more wording than our
form, but the basic idea is always the same.
only the original of the promissory note. When it's
paid off, you're entitled to get it back. If you
let signed copies float around, that can cast doubt
on whether the debt has been fully paid. The only
exception to that rule is a photocopy of the signed
note marked "COPY" that you should keep
for your business records. Keep that strictly confidential.
If the interest rate on the loan doesn't exceed
the maximum rate allowed by your state's usury law,
you and the lender are free to work out the terms
a state's usury law will allow a lender to charge
a higher rate when lending money for business purposes
than for personal reasons. In several of these state
laws, there's no limit on the interest rate that
can be charged on business loans as long as the
business borrower agrees to the rate in writing.
In a few states, the higher limit or absence of
any limit applies only when the business borrower
is organized as a corporation. In other states,
the higher rates permitted for business borrowers
are legal even if the borrower is a sole proprietorship,
partnership, or limited liability company.
When checking your state's law,
look under "interest" or "usury"
in the index to your state's statutes.
aren't any usury law problems, you and the lender
can agree on any number of repayment plans. Let's
say you borrow $10,000 with interest at the rate
of 10% a year. Here are some repayment possibilities:
- Lump sum repayment. You agree, for example, to pay principal
and interest in one lump sum at the end of one
year. Under this plan, 12 months later you'd pay
the lender $10,000 in "principal" --
the borrowed amount -- plus $1,000 in interest.
- Periodic interest and lump sum repayment of
You agree, for example, to pay interest only for
two years and then interest and principal at the
end of the third year. With this type of loan
plan, often called a "balloon" loan
because of the big payment at the end, you'd pay
$1,000 in interest at the end of the first and
second years, and then $10,000 in principal and
$1,000 in interest at the end of the third year.
- Periodic payments of principal and interest. You agree, for example, to repay $2,500
of the principal each year for four years, plus
interest at the end of each year. Under this plan,
your payments would look like this:
End of Year One: $2,500 principal
+ $1,000 interest
End of Year Two: $2,500 principal
+ $750 interest
End of Year Three: $2,500 principal
+ 500 interest
End of Year Four: $2,500 principal
+ $250 interest
- Amortized payments. You agree, for example, to make equal
monthly payments so that principal and interest
are fully paid in five years. Under this plan,
you'd consult an amortization table in a book,
on computer software, or on the Internet to figure
out how much must be paid each month for five
years to fully pay off a $10,000 loan plus the
10% interest. The table would say you'd have to
pay $212.48 a month. Each of your payments would
consist of both principal and interest. At the
beginning of the repayment period, the interest
portion of each payment would be large; at the
end, it would be small.
- Amortized payments with a balloon. You agree, for example, to make equal
monthly payments based on a five-year amortization
schedule, but to pay off the remaining principal
at the end of the third year. Under this plan,
you'd pay $212.48 each month for three years.
At the end of the third year after making the
normal monthly payment, there'd still be $4,604.42
in unpaid principal, so along with your normal
payment of $212.48, you'd make a balloon payment
to cover the remaining principal.
loans with prepayment penalties. Whenever you borrow money, you'd like to be free to reduce or pay off the
principal faster than called for in the promissory
note if you have the wherewithal to do so, since
this reduces or stops the running of interest. In
other words, if you have a three-year loan but are
able to pay it off by the end of year two, you don't
want to pay interest for year three. By law, some
states always allow such early repayment, and you
pay interest only for the time you have the use
of the borrowed money. In other states, however,
the law allows a lender to charge a penalty (amounting
to a portion of the future interest) when a borrower
reduces the balance or pays back a loan sooner than
called for. Because it seems unfair to have to pay
anything for the use of borrowed money except interest
for the time the principal is actually in your hands,
try to make sure any promissory note you sign says
you can prepay any or all of the principal without
penalty. If the lender doesn't agree, see if you
can negotiate a compromise under which you'll owe
a prepayment penalty only if you pay back the loan
during a relatively short period, such as six months
from the time you borrow the money.
Lenders usually require you to provide some valuable
property -- called security, or collateral -- that
they can sell to collect their money if you can't
keep up with the loan repayment plan. A
lender, however, isn't limited to using the pledged
assets to satisfy the loan. If you don't make good
on your repayment commitment, a lender also has
the right to sue you. Typically, a lender will seize
pledged assets first and then sue you only if the
funds realized from those assets are insufficient
to pay off the loan, but that's not a legal requirement.
If the lender wins the lawsuit, assets you haven't
specifically pledged as security, such as a portion
of your future earnings, are at risk.
you lack the assets that you need as security for
a loan, a microloan may be a good option for you.
Generally, these loans are quite small -- often
from $100 to $1,000. However, they can run up to
about $25,000. The companies that qualify are generally
those that can't get access to any other forms of
capital, either because they're start-ups or because
they're too small. Sometimes they're owned by people
whose personal credit histories are good in general
but might include problems that would scare off
Lenders that give
microloans accept collateral that regular banks
don't consider, like office equipment or the owner's
home washer or TV set. Such lenders will also overlook
some types of credit problems if they believe those
problems have been solved.
interest rates are much higher than typical loan
rates because their risks are higher: typically
12.5% to 15%. So, if you decide for a microloan,
it is a good idea to qualify for one and use it
to kickstart your company to the point that traditional
bank financing becomes feasible. After that, a traditional
loan will be a better option for you.
Another option for you, in case you lack sufficient
assets to pledge as security for a loan, is to get
someone else to cosign or guarantee the loan. If
you choose this option, the lender will have two
people rather than one to collect from if you don't
make your payments. Remember that the cosigner risks
their personal assets if you don't repay the loan.
the lender to choose youBankers
look for an ideal loan applicant, who typically
meets these requirements: