As a small business owner, financing your business is probably a top concern of yours. After all, 82 percent of small businesses flop because of poor cash flow or money management—yipes! Having the right funding is crucial for getting your business off the ground and in flight.
Obtaining that funding can be a difficult process—you have to know your way around a bunch of jargon. What’s more, big banks only approved 23 percent of loans as of March 2016. You’ll improve your chances of qualifying for a traditional small business loan if you brush up on what you’re getting yourself into.
Here are 10 terms to get nice and cozy with to simplify the loan process— you’ll be much better equipped to find the financing you need for your small business.
1. Term loan
A term loan is the bread-and-butter of small business financing. It’s a lump sum of money you borrow from the lender to put into your business, that you have to repay in installments (daily, weekly, monthly, and so on). A small business term loan can be used for a variety of purposes, like buying equipment or using it as working capital.
You can get a term loan from all kinds of sources, from major banks to online lenders. For example, the Small Business Administration (SBA) offers entrepreneurs a variety of term loans, from commercial real estate loans to disaster loans.
2. Line of credit
A line of credit functions much like a credit card. When you’re approved for a line of credit, you’re free to draw funds as you need (up to a limit). You only have to pay interest on the money that you actually borrow.
A small business line of credit is a solid option for any business; it provides you with incredible flexibility in how you use your funds. The money has to be used for business expenses, though (no hot air balloon rides!).
Most people think that APR is synonymous with interest rate, but this isn’t the case. APR (which stands for annual percentage rate) includes the interest rate plus additional fees, like the origination fee, documentation fees, and closing fee.
APR gives you a more comprehensive look at how much a small business loan will cost you. An interest rate on a loan can be misleading, especially if fees are high. Make sure you know what you’re signing for on the dotted line.
4. Origination fee
The definition of this term is what it sounds like: it’s a fee the lender charges when you enter the loan agreement. It covers the costs of setting up and processing the loan and is usually expressed as a percentage of the total loan amount, such as 2.5 percent, or an actual amount, like $500.
4. Maturity date
Before you agree to financing for your business, note the maturity date of the loan, credit line, or other type of funding in question. That date is when you’ll have to have paid the principal and remaining interest and fees in full.
Beware of balloon loans, which only ask for small payments for each installment, but then require a large final payment to pay off the balance. Actually repaying the loan in full on that maturity date could be difficult, if not impossible, for many small businesses.
Amortization is when you gradually pay off an obligation through periodic payments of principal and interest. So when you get approved for a small business loan, you’ll likely receive an amortization schedule.
The amortization schedule basically shows what you’re paying in principal, interest, fees, and other expenses for each installment until the loan is paid in full. Chances are you’ll like looking at the amortization schedule even more as you get further into repayment (it’s quite exciting to watch the loan balance go down to zero!).
Small business loan brokers help with navigating the financing process. Essentially, their job is to connect you with funding that suits the needs and financial situation of your company.
While it sounds like brokers are out to help you, that’s not always the case. Some have been known to be misleading or even predatory (look out for sharks!). This is why it’s crucial that you ask the right questions and understand their incentives.
For example, you should ask about broker fees and compare with others. You should always inquire about the total cost of the loan—not just the interest rate. The broker should also give details on how loans are searched and compared. And, you should ask how the broker is compensated; see if he or she is incentivized to push for one loan type over another.
8. Prepayment penalty
So, you took out a small business loan. You successfully put that money to work. Now, your company is the talk of the town and you’re in a position to pay that money back early. Congrats! The only problem is that your loan has a prepayment penalty. D’oh!
A prepayment penalty is a penalty or fee for paying back your loan early. If you think that’s unfair, you’re not alone. Fortunately, many lenders don’t charge a prepayment penalty, but you should still check for one before you take out a loan.
9. Factor rate
You’ll encounter a factor rate when you apply for a merchant cash advance or short-term loan, which is a business cash advance that is repaid by taking a percentage of your daily credit card sales. Merchant cash advances are a great option if you need an immediate cash infusion, but they can get costly (even though the factor rate may look nice at first glance).
Expressed in a decimal figure, a factor rate shows you how much you’ll pay back on your loan. Factor rates usually range from 1.1 to 1.5, depending on the age and financial health of your business, industry, and average monthly credit card sales. For instance, if you get an advance for $10,000 at a factor rate of 1.25 for a 12-month term, you’ll repay a total of $12,500. You simply multiply the loan amount by the factor rate.
Interest rates and factor rates might sound like they’re the same thing, but nope—there are a few important differences. Factor rates are calculated one time based on the original loan. Interest rates are continually calculated based on the current principal (which goes down over time). That’s why the cost of merchant cash advances is usually much greater than small business loans.
According to the SBA, collateral for small business financing is “personal and business assets that can be sold in case the cash generated by the small business is not sufficient to repay the loan.”
Many small business loans require some sort of collateral, with some exceptions. It’s a way for the lender to lower the risk of extending you money. It’s not an arm or a leg, but you usually have to provide some form of collateral, like equipment or real estate.
Making small business financing work for you
You’re a boss! Understanding this common terminology can help you take command of the financing process for your small business. Now, when you get small business financing, you’ll be ready to put that money to work!