You’ve just received a prospective small business loan agreement, and it’s full of arcane terms like “blanket lien,” “principal,” and “amortization.” When you’re deciding on the best way to borrow money, it’s essential to know what you’re getting into. Small business loan terms can be confusing— but don’t worry, because we’ve got you covered.
Here’s our guide to many of the terms you’ll find in typical small business loan agreements.
Terms Explaining How Much Your Small Business Loan Will Cost
The best financing deal for your business will include the amount you need to borrow with a reasonable repayment schedule. You’ll want to look at:
The Principal of the Loan
Principal is simply the amount of money you’re borrowing before interest. This is the total amount that a lender will provide you in financing. Principals may be provided as a lump sum or as a line of credit or another kind of advance that can be withdrawn as-needed, over time.
The Annual Percentage Rate (APR) of the Small Business Loan
Annual percentage rate is the total amount of interest paid on a loan over the course of a year. You will generally want to keep the APR as low as possible, as the higher the APR, the more you’ll repay in interest. Although the APR is a useful basis for comparison, it’s not foolproof. For example, depending on the lender the APR may not take into account:
- The full range of charges that a lender will apply to a small business loan.
- The inclusion or exclusion of certain fees.
- The impact of compounding interest on the final amount you will pay.
The Impact of Compounding Interest
Compounding interest is interest charged on your principal plus your previous interest, less the amount you’ve already repaid. Borrowers typically compound interest on a daily or monthly basis. For example, you borrow $100,000 at an APR of 20 percent, compounded daily. That APR works out to effectively charge 0.05 percent interest per day, and is added to the amount you owe.
- On day one, your outstanding balance is $100,000, and you are charged interest of 0.05 percent, or $50, which is added to your balance.
- On day two, your outstanding balance is $100,050, and you are charged interest of 0.05 percent, or $50.03, which is added to your balance.
- On day three, your outstanding balance is $100,100.03, and you are charged interest of 0.05 percent, or $50.05, which is added to your balance.
- And so on, with the balance only reducing once a repayment is made.
This can make figuring out how much you’ll need to repay more complex. To make it easier, always look for a dollar amount in your loan agreement that shows the likely total amount of interest to be charged.
Fixed or Variable Rates of Interest on Your Small Business Loan
Next, you’ll want to know if the amount of interest you’re charged is likely to change over the duration of the loan. If you have a fixed-rate agreement, the interest rate will stay the same for the whole duration. If you have a variable-rate loan, the interest rate may go up and down, typically in line with the base interest rate that’s set by the Federal Reserve.
The Duration of Your Small Business Loan
Due to compounding, the longer the loan you have, the more you’ll pay through interest. Most standard small business loans run for three years (36 months) or five years (60 months), although they can be longer or shorter. If you want to keep your interest rate down, you should aim to repay the loan as quickly as possible.
- For example, if you borrow $50,000 at an APR of 15 percent, with interest compounded daily.
- Repaying the loan over three years will mean you’ll pay around $12,500 in interest.
- Repaying the loan over five years will mean you’ll pay around $21,500 in interest.
- The difference of $9,000 is due to compounding over those two years, and the lower monthly repayments you will make.
Setup Costs for Your Loan
Some lenders may charge to set up a loan and provide you with financing. Typically, you’ll be charged an upfront percentage of the total amount you’re borrowing, although some lenders may request a fixed fee. Not all lenders charge an initiation fee.
Terms Explaining the Repayments of Your Loan
Now you know what your small business loan will cost, it’s important to understand how you will pay it off.
Amortization and Repayments
Firstly, you’ll want to know if your loan is “amortized.” If it is (which is normal), you’ll make equal, regular, scheduled payments to repay the loan over the agreed duration. If your loan isn’t amortized, then a lender should declare how your repayments will work.
Your Total Amount Repayable
Ideally, you’ll want to know how much your total repayment will be, which is a combination of principal and interest. If your loan agreement doesn’t show the total amount repayable, you can use a loan calculator to figure out repayments including compounded interest.
Your Repayment Amount and Frequency
This will show how much you’re expected to repay on your loan and how often. Most small business loans will have a monthly repayment frequency, although this can vary. You will need to pay at this frequency throughout the duration of your loan.
Early Repayment Charges
Many lenders will allow you to make additional overpayments on your loan, or pay off your loan early. In some cases, there may be an additional charge for this, which will be stated in the loan agreement.
Terms Explaining How a Lender Will Ensure Repayment of Your Small Business Loan
Lenders want to reduce the financial risks they take when lending money. They will use various means to achieve that.
Secured Small Business Loans
A secured small business loan typically means that you provide “collateral” against the amount you borrow. Collateral could be something like business property, business vehicles, inventory, accounts receivable, or any other business asset that has a dollar value. If you fail to meet the repayment terms and default on your debt, the lender is entitled to seize and sell your collateral to reduce their losses.
Unsecured Small Business Loans
An unsecured business loan means your business will not have to provide specific collateral to secure the debt. Instead of requiring collateral, lenders will most often require one of the following:
- A “Blanket Lien” on your business: This means a lender has the right to seize and sell any of your business assets if you default on your debt.
- A “Personal Guarantee” you will repay the loan: This means a lender has the rights to seize and sell any of your personal assets (like your home, car, or bank account) if you default on your debt.
If your small business loan includes a personal guarantee or a blanket lien, be sure you know how you could be liable if you default on your debt.
Terms Explaining Penalties and Defaults
If you fail to make a repayment on your loan on time, you may be subject to the following:
- Penalties and extra charges: The lender may impose fixed fees or extra interest charges if a payment is late.
- Defaults: If you fail to make sufficient repayments over a specific time period, you will “default” on your debt. This will result in a derogatory mark on your credit report and may entitle the lender to seize assets to recoup their losses.
Some lenders may provide a “grace period” on a late repayment. Check with your loan provider.
We hope you’ve found this guide to the most common small business loan terms useful. If you have any questions about the funding terms on your loan, please get in touch.