How Does a Business Loan Work?
A business loan is an agreement
between your business and a lender in which you agree to pay an interest rate on
a specific amount of capital borrowed over a specified period of time. As we
have discussed earlier, a business loan works very much in a similar fashion to
a mortgage. You are lent money and required to pay back the principal and
interest. However, there are a number of differences between business loans and
other types of loans. As we saw earlier, business loans often come with a
substantial number of covenants. These covenants act as a guide of factors that
your business must adhere to throughout the life of the loan. Sample covenants
include, but are not limited to:
- Maintaining
profitability
- Maintaining a
positive cash flow that exceeds the interest and principal repayment by a
certain factor.
- Maintaining
the value of collateral
- A stringent
use of how the business loan is to be used.
- Maintaining a
strong credit score (both for the business and personally).
Banks and finance companies
have a wide range of latitude when determining whether or not to make a business
loan, how the loan proceeds can be used, the interest rate, and the repayment
period. Of course, like with anything in this world, you are free to reject an
offer proposed by a lending bank. The only factor that cannot be taken into
account when making a credit decision is someone’s race, religion, or other
similar characteristics.
In regards to the mechanics of
the business loan, a bank or finance company can issue the funds in a number of
different ways. First, they could simply write you a check to be deposited into
your bank account. However, this is become less frequent as banks want to ensure
that the usage of debt funds is in accordance with how you said you would use
them. In a different scenario, you could have the bank make purchases of items
on your behalf. For instance, if you took out a $50,000 loan to buy a piece of
business machinery, then the bank very may well directly pay the vendor for the
equipment rather than you paying the vendor. This ensures the bank that the
funds have been used appropriately and that the proper collateral is in place.
In other articles, we will
further address the mechanics of business loans and business credit facilities.