By Jared Hecht
If you’re just beginning your hunt for business financing, you’re likely knee-deep in unfamiliar terms and lending jargon. And it’s enough to make even the most eager entrepreneur feel overwhelmed. Don’t continue your search without reviewing a few of the essential terms you need to know to make an informed decision about financing your business. We’ve broken down eight must-know terms below.
1. Term loan.
Term loans are a lump sum of cash you pay back, plus interest, over a fixed period of time. Traditional term loans usually offer longer payment terms and lower monthly payments than short-term loans and other forms of emergency financing.
Securing a term loan, however, requires a high degree of creditworthiness on the part of your business. If your business is very young, has poor credit, or presents any other kind of risk to your lender, you may find it difficult to secure a term loan from a traditional lender.
2. SBA loan.
Small Business Administration loans offer even longer terms and lower costs than traditional term loans, as they come partially guaranteed by the U.S. government. SBA loans are specifically designed to give small business owners the most affordable financing possible as they grow their businesses. (Brace yourself, however, for a long and competitive approval process and lots of paperwork.)
3. Line of credit.
Another popular loan product your lender might offer is a business line of credit. This kind of financing provides a borrower with revolving credit, allowing you to borrow and pay back that borrowed amount over and over while staying within a maximum, as you would with a credit card. Unlike a loan, a line of credit offers you capital as needed, and you’ll only pay interest on what you withdraw.
4. Annual percentage rate.
An annual percentage rate, or APR, is essentially the annual cost of your loan. It’s quoted as a percentage, like your interest rate, but provides a more accurate view of what your loan will cost you. In addition to interest owed, your APR will also include any origination fees, closing fees, documentation fees, etc. The APR offer you receive will vary from lender to lender, based on the loan product you’re seeking and your history as a borrower.
If you’ve been eyeing a loan, be sure to consider its APR before moving forward. The loan’s total annual cost could be higher than you anticipated.
5. Income statement.
An income statement details your business’s net income, revenue and expenses for a specific period, such as quarterly or annually. You’ll come across this term when filling out your loan application. It’s one of the most important components of your application. You might also see it called a “profit and loss statement.”
This document illustrates your business’s financial health and the strength of its bottom line to your lender. You can prepare your statement yourself or with the help of an accountant. Income statements come with their own set of jargon, so it helps to familiarize yourself with their vocabulary before diving in on your own.
Collateral describes any asset you pledge to a lender to help secure a loan. This could include real estate, equipment, accounts receivable, inventory — anything a lender could liquidate if you default. Collateral minimizes the risk to your lender should you fail to hold up your end of the bargain.
If you’re considering a secured loan, expect to put up collateral when you apply. Unsecured loans won’t require collateral and typically come with less stringent credit requirements, but also higher rates.
7. Personal guarantee.
If you agree to a personal guarantee when taking out a loan, you commit to being personally responsible for your debt in the event of default. Unlike collateral, this type of security allows a lender to seize personal assets if you can’t pay back your loan — assets like your retirement fund, your car, or your house. Limited personal guarantees put a cap on how much can be collected, while unlimited personal guarantees allow a lender to pursue you until your debt is repaid.
Personal guarantees can be vaguely or confusingly worded, so it’s best to consult with a legal professional before accepting a loan with a personal guarantee.
8. Debt-service coverage ratio.
Your debt-service coverage ratio, also known as the debt coverage ratio, is the ratio of cash a business has available for servicing its debt, which includes making payments on principal, interest and leases. It is computed by dividing a business’s cash flow (more specifically, net operating income) by the debt service payments (loan and lease payments). If your business owes more than it earns, you’ll have a DSCR of less than one. If you’re on top of your debt, you’ll see a DSCR of one or greater. Most lenders want to see a DSCR of 1.25 or above. They want borrowers who can afford to take on new debt, along with some extra cushion.
This is not an exhaustive list by any means. But we hope that it will help point you in the right direction. The more you understand the lexicon of small business loans before you start your search, the better you’ll be able to secure the right loan for you. –Entrepreneur