Small-business loans can offer some financial security – consider the advantages and disadvantages before taking this step.
Fixed overhead costs can be stressful for small-business owners, and a small-business loan can offer some financial security. Before taking this step, however, you have to carefully consider the advantages and disadvantages.
Here is a summary of the pros and cons.
Pros
Plenty of options
The first decision to make is the type of loan that is most suitable for your business:
- capital loans help the business support its monthly or cyclical capital costs
- lines of credit increase your working capital for inventory, equipment and general cashflow needs.
You then need to choose the best provider for the type of loan. Look at a range of options and compare their terms, loan security requirements and the reputation of the lender. A common mistake many SME owners make is only considering banks many financial institutions offer competitive rates with variable loan terms.
Lower interest rates & flexible payment terms
Bank loans offer slightly lower interest rates compared to other lenders, though their loans are typically harder to obtain and involve a more complex application process. Most banks have the ability to offer a ‘no maximum loan’ with up to 25 years payment option, but these usually have a higher interest rate.
Secured loans can offer as low as 5.85% interest on variable basis, but not all loans are based on interest rates. Some financial institutions offer a fixed total payback amount that tells the borrower the total cost of the loan upfront and that is immune to interest rate fluctuations.
Fast approval and availability of funds
Many lenders have the capacity to advise you of your borrowing capacity within a few minutes. Make sure you have all the information they require to make the process as quick as possible. You need to provide them with:
- purpose of the loan (i.e. inventory, equipment, or operational costs)
- type of business (seasonal businesses such as a swimwear shop may not be offered as much money as a café)
- loan security (are you or aren’t you able to offer collateral)
- bank account details.
This speeds up the approval process, allowing you to move on and apply with other lenders if you aren’t successful.
Tax deductions
Business loans are not taxable income, but the actual loan proceeds that become a part of the working capital are invariably treated as taxable income by default, so you should document any loans and apply for the applicable deductions when you submit your tax return.
Cons
Most banks favour secured loans
Not all small-business owners and start-ups have the means to buy and maintain real-estate properties, making them ineligible for small-business loans from the majority of banks, who only offer secured loans. Some banks do offer non-secured loans but the loan amount is usually lower and/or they require repayment over a shorter term.
A common mistake many SME owners make is only considering banks.
Preference is given to established businesses
Many lenders prefer current customers and businesses with a proven credit history and profitability, making it difficult for new customers to obtain a loan. Keeping accurate records of your trading history and invoices—even if you are a fledgling business – will increase your chances of obtaining a competitive loan.
Lack of choice for small-business loans
There commercial lending sector is enormous, but small-business lending is an entirely different scenario. According to the World Bank, there is a great need to strengthen the institutional environment so SMEs can have access to a wider range of loan options.
Banks enforce strict criteria such as a flawless credit rating, hard assets, and a minimum two years’ tax statements. However, now more and more financial institutions offer easier-to-obtain loans with online prequalification, and these are proving popular with SMEs.
Loans do not guarantee business improvement
Most lenders only approve 70% to 80% of the original loan request amount, so obtaining a loan does not always enable you to do everything you planned. In such a case you need to make the relevant adjustments to your business plan, and if the loan no longer offers value for money, do not proceed.
Loans are negative assets and if you do not manage them well you can struggle with the accumulating interest. It is prudent to consider taking out a smaller loan at first, make sure you can manage it and then increase your borrowing.
John de Bree, Managing Director, Capify
This article first appeared in issue 11 of the Inside Small Business quarterly magazine
