Loans - The Basics
loan is based on a simple idea: Someone gives you money,
and you promise to pay it back, usually with interest. The
entire risk of your enterprise is placed on your shoulders.
To help keep the risk low, a lender will very likely ask
for security for the loan -- for example, a mortgage on
your house so that the lender can take and sell your house
if you don't keep up your loan payments.
If you're confident about the future of your business and
you have the opportunity to borrow money, a loan is a more
attractive source of money than getting it from an equity
investor, who will own a piece of your business and receive
a share of the profits. However, you don't have to repay equity
investors if the business goes under.
case you decide on a loan, here are the basics.
A lender will almost always want you to sign a written promissory
note -- a paper that says, in effect, "I promise to
pay you $XXX plus interest of XX%" and then describes
how and when payments are to be made. A bank or other commercial
lender will use a form with a bit more wording than our
form, but the basic idea is always the same.
only the original of the promissory note. When it's paid
off, you're entitled to get it back. If you let signed copies
float around, that can cast doubt on whether the debt has
been fully paid. The only exception to that rule is a photocopy
of the signed note marked "COPY" that you should
keep for your business records. Keep that strictly confidential.
If the interest rate on the loan doesn't exceed the maximum
rate allowed by your state's usury law, you and the lender
are free to work out the terms of repayment.
state's usury law will allow a lender to charge a higher
rate when lending money for business purposes than for personal
reasons. In several of these state laws, there's no limit
on the interest rate that can be charged on business loans
as long as the business borrower agrees to the rate in writing.
In a few states, the higher limit or absence of any limit
applies only when the business borrower is organized as
a corporation. In other states, the higher rates permitted
for business borrowers are legal even if the borrower is
a sole proprietorship, partnership, or limited liability
When checking your state's law,
look under "interest" or "usury" in
the index to your state's statutes.
If there aren't
any usury law problems, you and the lender can agree on
any number of repayment plans. Let's say you borrow $10,000
with interest at the rate of 10% a year. Here are some repayment
- Lump sum repayment. You agree, for example, to pay principal
and interest in one lump sum at the end of one year. Under
this plan, 12 months later you'd pay the lender $10,000
in "principal" -- the borrowed amount -- plus
$1,000 in interest.
- Periodic interest and lump sum repayment of
You agree, for example, to pay interest only for two years
and then interest and principal at the end of the third
year. With this type of loan plan, often called a "balloon"
loan because of the big payment at the end, you'd pay
$1,000 in interest at the end of the first and second
years, and then $10,000 in principal and $1,000 in interest
at the end of the third year.
- Periodic payments of principal and interest. You agree, for example, to repay $2,500
of the principal each year for four years, plus interest
at the end of each year. Under this plan, your payments
would look like this:
End of Year One: $2,500 principal + $1,000
End of Year Two: $2,500 principal + $750
End of Year Three: $2,500 principal +
End of Year Four: $2,500 principal +
- Amortized payments. You agree, for example, to make equal
monthly payments so that principal and interest are fully
paid in five years. Under this plan, you'd consult an
amortization table in a book, on computer software, or
on the Internet to figure out how much must be paid each
month for five years to fully pay off a $10,000 loan plus
the 10% interest. The table would say you'd have to pay
$212.48 a month. Each of your payments would consist of
both principal and interest. At the beginning of the repayment
period, the interest portion of each payment would be
large; at the end, it would be small.
- Amortized payments with a balloon. You agree, for example, to make equal
monthly payments based on a five-year amortization schedule,
but to pay off the remaining principal at the end of the
third year. Under this plan, you'd pay $212.48 each month
for three years. At the end of the third year after making
the normal monthly payment, there'd still be $4,604.42
in unpaid principal, so along with your normal payment
of $212.48, you'd make a balloon payment to cover the
with prepayment penalties. Whenever you borrow money, you'd like to be free to reduce or pay off the
principal faster than called for in the promissory note
if you have the wherewithal to do so, since this reduces
or stops the running of interest. In other words, if you
have a three-year loan but are able to pay it off by the
end of year two, you don't want to pay interest for year
three. By law, some states always allow such early repayment,
and you pay interest only for the time you have the use
of the borrowed money. In other states, however, the law
allows a lender to charge a penalty (amounting to a portion
of the future interest) when a borrower reduces the balance
or pays back a loan sooner than called for. Because it seems
unfair to have to pay anything for the use of borrowed money
except interest for the time the principal is actually in
your hands, try to make sure any promissory note you sign
says you can prepay any or all of the principal without
penalty. If the lender doesn't agree, see if you can negotiate
a compromise under which you'll owe a prepayment penalty
only if you pay back the loan during a relatively short
period, such as six months from the time you borrow the
Lenders usually require you to provide some valuable property
-- called security, or collateral -- that they can sell
to collect their money if you can't keep up with the loan
repayment plan. A
lender, however, isn't limited to using the pledged assets
to satisfy the loan. If you don't make good on your repayment
commitment, a lender also has the right to sue you. Typically,
a lender will seize pledged assets first and then sue you
only if the funds realized from those assets are insufficient
to pay off the loan, but that's not a legal requirement.
If the lender wins the lawsuit, assets you haven't specifically
pledged as security, such as a portion of your future earnings,
are at risk.
lack the assets that you need as security for a loan, a
microloan may be a good option for you. Generally,
these loans are quite small -- often from $100 to $1,000.
However, they can run up to about $25,000. The companies
that qualify are generally those that can't get access to
any other forms of capital, either because they're start-ups
or because they're too small. Sometimes they're owned by
people whose personal credit histories are good in general
but might include problems that would scare off traditional
Lenders that give microloans accept
collateral that regular banks don't consider, like office
equipment or the owner's home washer or TV set. Such lenders
will also overlook some types of credit problems if they
believe those problems have been solved.
microloan interest rates are much higher than typical loan
rates because their risks are higher: typically 12.5% to
15%. So, if you decide for a microloan, it is a good idea
to qualify for one and use it to kickstart your company
to the point that traditional bank financing becomes feasible.
After that, a traditional loan will be a better option for
Another option for you, in case you lack sufficient assets
to pledge as security for a loan, is to get someone else
to cosign or guarantee the loan. If you choose this option,
the lender will have two people rather than one to collect
from if you don't make your payments. Remember that the
cosigner risks their personal assets if you don't repay
the lender to choose youBankers
look for an ideal loan applicant, who typically meets these