How to Get a Bank Loan for Your Business - Business Tips # 3

The most common form of bank loan is a 90-day short-term unsecured loan Standard variations include loans made for periods shorter than 90 days (i.e., 30 or 60 days) and loans extended for up to a year and backed by collateral. These are known as secured loans. If you're familiar with accounting, you've probably already figured out that a short-term loan represents a current liability on your company's balance sheet, indicating that debt must be repaid within a year. Bank loans typically have an annual interest rate several points above the prime rate, much like consumer credit cards. In the past, the most common approach was to apply a simple interest rate to the loan, requiring that the debtor pay fixed payments over the life of the loan. More recently, banks have been charging a floating or variable interest rate, allowing the interest charges to vary according to fluctuations in the prime rate. Another trend has been to price the loan at a rate above the marginal cost of funds, which is typically reflected by the interest rates on certificates of deposit (CDs). This rate fluctuates daily according to changes in money market rates. In general, the amount of interest paid on a loan will depend on (1) the dollar amount of the loan, (2) the period of the loan, (3) the nominal annual rate of interest, (4) the repayment schedule, and (5) the method used to calculate the interest.

Often entrepreneurs can forecast the cash flow of their company and anticipate future periods when they will require money to pay for supplies or build up inventory. Instead of borrowing the cash now and paying unnecessary interest, they can apply to a bank for a line of credit an assurance by the bank that, as long as the company remains financially healthy, the bank will lend the company a specific amount of capital. This does not guarantee that the bank will lend the money, rather it ensures that when the business wants to draw against its line of credit, the bank will review the company's current financial statements to verify that it still qualifies for the loan. Under certain circumstances, a business can obtain a guaranteed line of credit that promises the company that the bank will lend it money regardless of its current financial position. As you can well imagine, banks charge extra for the guarantee, typically 1 percent a year on the unused portion of the line of credit. Moreover, a bank will frequently require that entrepreneurs maintain a compensating balance, holding a specific amount of money in their checking account without interest.

Banks will frequently require collateral from the entrepreneur in order to reduce the risk of making a loan. Collateral may be in the form of any asset that has measurable value, including equipment, property, or inventory. If the entrepreneur defaults on the repayment of the loan, the collateral becomes the possession of the bank, which may sell the assets in order to recoup its losses from the loan. With a small business, banks often require that the entrepreneur and his or her key managers personally sign for the loan, offering their personal possessions as collateral. Obviously, this puts the entrepreneur at great risk. However, the rationale of the banker dictates that if you're not willing to put up personal collateral for the loan, then the deal is too risky for the bank, and the bank will deny the credit altogether.

Though commercial banks and venture capitalists differ along almost every dimension, the one thing that's important to both is your business plan. Having a well-articulated, accurate business plan with solid numbers that predict positive financial performance will be important to obtaining a line of credit from a bank. However, unlike the venture capitalist, the banker does not search for outrageous growth rates and a high potential return on investment. In fact, the banker could probably care less how rapidly your company grows. He's interested in ensuring that your company will continue to remain healthy, producing financial results that will allow you to repay the loan according to the terms of the agreement. You must be able to validate your financial projections and explain your assumptions in a manner that convinces the banker that you run a sound business.