Start with a Financial Roadmap
The first step in any loan search is to make sure you have a business plan. It’s the guide that’ll help you identify how much money you already have available, how much you need to borrow, and when you need to receive that financing. Getting any of these answers requires you to gather bank statements and revenue reports so you can quantify the numbers and accurately project your future finances.
“Business plans are needed in almost every single successful business case,” explains entrepreneurship expert Paloma Cantero-Gomez. “Despite deviations, inexactitudes, and time-investment. Going deep into the Panel Study of Entrepreneurial Dynamics, Clemson University entrepreneurship professor William B. Gartner revealed how writing a plan significantly increased the chances to go into a real business. There is no goal achievement without goal and milestone setting.”
The bottom line is that it’s hard to get anywhere meaningful unless you know the destination and how to get there. Not only will your business plan serve as a north star throughout your financing journey, but it can be a powerful asset when you begin approaching lenders. A good business plan will show them how invested you are in your business and how well you understand the requirements of success.
Once you’ve identified the amount you’ll need to borrow for your small business loan, you can immediately begin eliminating unsuitable options. Remember, if you’ve got a large family and you’re on the hunt for a new vehicle, don’t want to waste time test-driving sedans. Focus on minivans, SUVs, and other large vehicles.
Narrowing the Field of Financing Options
Armed with your business plan, you’ll be able to identify a handful of options that could suit your needs. Here are some of the most popular financing products you’ll be choosing from:
- Business Line of Credit
- SBA Loan
- Short Term Loan
- Merchant Cash Advance
- Business Term Loan
- Business Credit Card
- Equipment Financing
- Commercial Mortgage
- Accounts Receivable Financing
- Startup Loan
- Business Acquisition Loan
This step is where precision comes into play. Just as vehicles have different trim levels, gas mileage, and safety features, loans have their own unique factors. These include the amount financed, funds disbursed, expected term, total repayment amount, and frequency of payback.
Of course, what you’ll be most interested in is determining the price. Is it difficult? To get a small business loan’s price, you’ll need to review multiple factors. Here’s a look at 6 of the most important:
1. Interest Rate: Anyone who’s taken out a loan to buy a car or home is familiar with the concept of interest. This percentage reveals how much the lender charges every year for the financing they provide. To calculate the rate, you’ll need to find a loan’s periodic interest rate, which should then be multiplied by the number of times the rate will be applied each year.
Interest rates are among the most fluid of the factors listed here. They rise and fall cyclically, impacted by numerous factors. Some entrepreneurs may believe that financing should only be pursued when interest rates are historically low, but there are benefits to your business when rates rise.
“Another potential long-term benefit of rising interest rates? Improved margins,” says Lendio CEO Brock Blake in a Forbes analysis of the impact of higher interest rates. “The underlying driver of a rate increase like this is inflation. When there’s mild inflation, prices for goods and services tend to move higher, giving small businesses room to increase their prices over time. With better cash flow and higher rates, you can improve your margins, leading to additional flexibility and breathing room.”
2. Cents on the Dollar: Sometimes, it’s helpful to break things down into familiar amounts. And is there anything more ubiquitous than a dollar? This metric reveals how much you’ll spend in interest and fees for every dollar borrowed.
3. Factor Rates: Lenders often employ this convenient metric as they quote their various loan products. The number is expressed as a decimal figure, revealing how much you’ll pay back to the lender. Factor rates are relevant for all types of loans, regardless of whether it’s short term financing or will be paid off over 3 decades.
For most borrowing scenarios, a loan’s factor rate is the amount you’ll need to pay back divided by the amount that has been funded. With merchant cash advances, the formula is different thanks to the distinct structure. Because the money in a cash advance is borrowed against future earnings, the factor rate is determined by dividing the purchase amount by the advance amount.
4. Annual Percentage Rate (APR): This number reflects the yearly cost of a loan. It includes all relevant transaction fees and is expressed as a percentage of the principal. It helps you refine your search, as it is easily correlated with your budget to show how much you can afford. Also, the APR allows for easier comparisons between different loan products.
Many small business owners confuse this metric with a loan’s interest rate. Despite the word “rate” appearing in both, the metrics are different. Also, it’s worth noting that while illuminating, APR isn’t a comprehensive metric because it doesn’t account for the effects of compounding.
“Take care when comparing the APRs of adjustable-rate mortgage loans,” advises a financial report from the Consumer Financial Protection Bureau. “For adjustable rate mortgage loans, the APR does not reflect the maximum interest rate of the loan. Be careful when comparing the APRs of fixed-rate loans with the APRs of adjustable-rate loans, or when comparing the APRs of different adjustable-rate loans. Be careful about comparing the APR of a closed-end loan, which includes fees, to the APR of a home equity line of credit, which doesn’t. Don’t look at the APR alone in determining what loan makes the most sense for your circumstances.”
5. Total Cost of Capital (TCC): Sometimes, you just want to see the full picture. By adding up the interest, fees that don’t charge interest, and additional fees, you get a more all-encompassing metric. The TCC for a loan may result in sticker shock, but it’s important to understand how all the factors interplay with each other. The TCC is also helpful when it comes to comparing one loan to another.
6. Average Monthly Payment: Since many small business owners operate on a monthly budget, it’s helpful to see how much you’ll be paying 12 times a year. Even if you have a financing product that requires daily or weekly payments, you can still deduce the monthly amount due.
Once you’ve identified the average monthly payment, you’ll have a clearer idea of how the loan would impact your short-term finances. And if you can afford the payments in this micro view, you can also afford it in the macro view provided by the APR and TCC.
The Challenges of Comparing Small Business Loans
While the aforementioned metrics can provide great assistance as you’re choosing between loan products, you’ll sometimes encounter challenges stemming from the fact that various lenders list disclosures differently. When metrics are determined inconsistently, it’s obviously difficult to find common ground for your comparisons.
Another issue that can arise is that lenders sometimes hide fees in their loan products. Whether it’s a late fee, processing fee, or early repayment fee, these ambiguous additions make it difficult to identify the true cost of a financing option.
Doing your due diligence is necessary throughout this process. By carefully studying the fine print, you’ll be able to root out sneaky fees. Some of them will turn out to be legitimate, while others could be murkier. What’s important is that you know exactly what you’re paying for.
Luckily, there are multiple resources available to help you compare loans. A small business loan calculator can simplify your efforts. Even if math is your forte, there’s no need to do all the work manually. Let technology carry some of the burden.
For a deeper dive, you can use a robust comparison tool called SMART Box™ (Straightforward Metrics Around Rate and Total cost). This resource was created by the ILPA, a partnership of leaders in the small business lending industry, to help borrowers cut through the confusion between loan products so they can make more informed decisions.
“It is important to note that the SMART Box is not intended to replace a lender’s existing disclosures or detract from the importance of providing clear and conspicuous information to a small business regarding the relevant finance product,” says the introductory statement on the ILPA’s website. “The SMART Box is instead intended to serve as a supplemental disclosure that presents key pricing information in a uniform fashion and helps to flag for the small business, in plain English, certain product features or policies. We ultimately believe that there are many responsible providers and products in the market, but these products often convey their pricing characteristics in different ways.”
There are 3 types of SMART Box™ tools, customized for popular families of loan products that share similar characteristics.
- Term loans
- Merchant cash advances
- Line of credit
If you find yourself struggling to get a clear picture of various loan costs, use SMART Box or a similar resource to establish a common language between the options. These resources are perfect examples of how technology is improving the lending process and making it easier for borrowers to get reliable answers.
Although calculators and comparison tools are crucial, they’re only effective when combined with careful consideration. You’ll need to read through every line of a lender’s disclosures, looking for anything that might alter your assumptions or present an unwelcome surprise after you’ve signed on the dotted line.
The small business experts from Lendio are happy to answer any questions you might have. They’re familiar with the top financing options and know how to locate the perfect fit. There is no cost or obligation when you speak with a Lendio expert, so if it sounds beneficial to your efforts, don’t hesitate to reach out by using our online contact form.