When we think of the term “loan” we usually think of the definition “When we lend or borrow money.” This business loan basics series will discuss business loans, how they work, and their pros and cons.
What is A Loan?
The official definition of a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient incurs a debt and is usually liable to pay interest on that debt until it is repaid, as well as to repay the principal amount borrowed. Wikipedia
When it comes to business loans, a business generally borrows money to be used for business purposes from a financial institution, usually a bank.
When considering any form of loan, but especially a business loan it is important to learn to some financial literacy basics to help you pick the best option for your current budget. Let’s take a look at things you should know before taking out a business loan.
Types of Loans
A loan is a sum of money that an individual or company borrows from a lender. It can be classified into various categories. Two of the main categories are unsecured and secured loans.
Unsecured: When a lender (the bank) lends money to the borrower (business) without asking for collateral or security
Secured: When a lender (the bank) lends money to the borrower (business) and the business has to give the bank some type of collateral or security in the form of assets
Other categories include:
Conventional, open-end, closed-end loans, personal loans, auto loans, student loans, mortgage loans, home equity loans, credit-builder loans, debt consolidation loans and payday loans, fixed-rate, and variable-rate.
Elements of a loan
When you take a loan you are using the lender’s / bank’s money. You have to pay the lender so that you to use their money.
A loan is made up of:
Principal or Capital: this is the amount of money you have borrowed.
Interest: the amount of money a borrower pays the lender in exchange for the privilege of using their money. The rate of interest is calculated at the onset of the loan and is added onto the capital amount.
Fees: These are charges that the borrower pays to the lender for taking the loan, usually for the preparation of agreement documents, opening the account.
Eligibility for a Loan
You cannot just walk into a bank and ask for a business loan and assume you will get it. There is a process in applying for a loan and once your application is submitted the bank will then determine if you are eligible or qualify for the loan.
Capacity measures your ability to repay the debt based on your current obligations.
Here, your cash flow is paramount, along with your debt-to-income ratio. Lenders want to know how much you owe versus how much you own. The lower your debt-to-income ratio, the more favorably a bank will look at your request for credit.
Other important things to know
- Loan Interest
Earning interest income is the most fundamental incentive for banks to issue a business loan to companies. Commercial banks lend as much money as they can at all times. The interest rate depends on the rules and regulations set by the Central Bank. When taking a loan be very sure as to what interest rate is being charged and on your repayment what part is going towards repayment of the capital amount and what part is going towards the interest.
02. Collateral
When taking out a business loan the bank will ask for collateral from you. Collateral is an item of value that a lender can seize from a borrower if he or she fails to repay a loan according to the agreed terms.
Generally, your lender must document and verify your income, employment, assets, debts, and credit history to determine whether you can afford to repay the loan.
Loans and borrowing can be complicated but once you have a basic understanding you can then determine whether your business requires a loan or not.
Some questions to consider before deciding to take out a loan:
1. How much money do you need?
2. How much do you want to pay monthly?
3. How much time do you wish for repayment?
When considering a loan do not let these terms and financial figures overwhelm you. Bring clarity and understand to your business budget in our workshop – Business Budget Basics. Sign up here!
Email us with any questions you may have about business loans and budget basics. As well, join us next month as we discuss the pros and cons of Business Loans.
