A loan is probably the most flexible way to raise finance to buy a business or start a business.
But that is not the only decision you will need to make – what kind of loan do you want to take out?
The principal variables are:
- The size of the loan
- The length of the repayment period
- The interest rate
- Whether the loan is secured or unsecured
- Whether the loan is fixed or variable
- Whether the loan is fixed or flexible
While it might be tempting to pay the loan off as quickly as possible, thereby minimising interest payments, you need to ensure that you can afford the payments. Loans are typically available for anywhere between one and 15 years.
Secured versus unsecured loans
There is a correlation between the level of risk you are willing and able to bear (how many of your assets will you use as security, and therefore risk sacrificing?) and the size of loan and interest rates financial providers are prepared to offer.
Most start-up entrepreneurs will take out secured loans. This means they secure the loan with assets, which will be property for most people.
Lenders will be able to offer bigger loans with more favourable interest rates with secured loans as they can recoup their money through the value of assets if people default on their repayments.
If you establish a limited company then you are limiting your personal risk; the company will shoulder as much of the debt as can be paid for by its assets. If you form a partnership or establish yourself as a sole trader then the lender will try to recover the debt from you.
Try to get the bank to agree to give written notice of an alleged default on payment and provide for a reasonable period over which to make the payment. If there is a clause placing the burden of costs resulting from enforcement of the loan on you – as there likely will be – try also to get a qualifier stipulating that only ‘reasonable solicitors’ fees’ will be levied for enforcement of the loan.
Unsecured loans have higher interest rates because the lender is taking on all of the risk.
Fixed rate versus variable rate
If you take on a fixed rate mortgage then the interest rate you get at the outset will remain the same throughout the repayment period. A variable rate on the other hand responds to market fluctuations.
If interest rates are particularly low at the time when you take out a loan then it is obviously better to get a fixed rate. If you have sufficient knowledge of the economy to make an educated forecast that interest rates will be lower for much of the repayment period, then you might be tempted by a variable rate loan. It is obviously easier to plan financially if you take out a fixed rate loan, as it reduces the need for safety margins in your cash flow calculations.
There is a third, mixed option: the capped loan. This means the interest rate reflects market fluctuations, but won’t go above an upper limit.
Fixed versus flexible
You can have fixed repayment periods or flexible repayment periods. This means you either have to pay fixed amounts to the lender over a fixed period, or have the option, if you have the means, to pay the loan back earlier.
If you have the option of paying the loan off earlier then it is obviously cheaper and means you have one less outgoing to worry about in future. However, many lenders charge prepayment penalties, which you should ask about when looking for a loan.
It is advisable to seek financial advice before setting your repayment period. It is important to ensure that the size of your repayments leave enough room in your cash flow projections for unforeseen circumstances, but that your repayment period is not unnecessarily long as you will pay more interest.
Boost your short-term cash flow
Starting a business can be financially fraught. A lot of initial investment on premises, equipment and marketing is often needed, not to mention the costs that arise from the inevitable inefficiencies of your business in its early days.
Discounted loans are useful for alleviating some of this stress. By paying a higher interest rate later, you can pay a lower one for an initial period to boost your short-term cash flow. You can even get this discount up front by taking out a cashback loan.
A third option is to take out a payment holiday loan, where if after a certain period you have reliably met all your repayments on time, you are permitted to skip a number of payments, which can be paid at a later date.
You can also pay a number of regular small payments, with one large ‘balloon’ payment to be paid at the end. This is beneficial for your short-term cash flow, but requires fiscal discipline to ensure there is a substantial amount of cash to pay the last installment.
Even better for your short-term cash flow is paying only the interest on your repayments, until one final balloon payment, which covers the rest of the outstanding balance. Again, this requires fiscal discipline and means you pay more interest.
If your lender agrees, you can pay nothing until a specified date in the future, at which point you pay the loan amount and all accrued interest. This is usually done for a short-term loan.
Equipment financing
Equipment financing is easier to obtain because the equipment itself is collateral for the loan. It is wise to take out the loan for a period commensurate with the expected life of the asset.
Whichever option seems right for you, it might be wise to consult with your accountant or tax advisors before finalising a loan.
