When a business takes out a loan, repayments will be determined by specific terms and conditions. The terms and conditions like the interest rate, loan duration, and repayment schedule will determine how much and how often a business must repay their loan.
The terms and conditions of a loan can dictate many aspects of the business, including cash flow management and future goals. That’s why business owners must choose terms that are compatible with their business’s finances and will support their goals for the future. Here are some of the ways loan terms can affect your business:
Cash Flow Management
When you take out a business loan, it’s crucial to prioritise loan repayments to avoid defaulting. If your loan terms lead to larger repayments, your business’s cash flow can be strained. With limited funds, businesses can struggle to pay for operational expenses like payroll and utility bills. It’s important to apply effective cash flow management strategies to ensure your business can cover its operational expenses while meeting loan repayment obligations.
Capital Allocation
Loan terms can dictate how businesses allocate their capital. For example, loans with higher rates and shorter terms may require large portions of revenue to go towards loan repayments. With less capital, businesses can miss out on investment, innovation, or marketing opportunities that can help grow the business.
Access to Future Financing
The terms of existing loans can influence a business’s ability to secure additional financing. If you choose favourable terms that lead to manageable repayments, you’re more likely to successfully repay the loan. Lenders will then see your capacity to repay, which can help you get more financing, potentially with even better terms.
Credit Score Impact
Compliance with loan terms affects a business’s credit score. Consistent, on-time loan repayments can improve a business’s credit score, increasing its chances of securing favourable loan terms in the future. Conversely, late payments or defaults can damage the business’s credit score, making future borrowing more difficult and expensive.
Financial Flexibility
Flexible loan terms, such as the ability to refinance or adjust payment schedules, can provide a business with more breathing room to navigate periods of financial difficulty or take advantage of emerging opportunities. In contrast, rigid loan terms might lock a business into a long-term commitment that could hinder its ability to adapt to market changes or take on business opportunities.
Operational Restrictions
Some loans come with covenants or restrictions that can impact business operations, such as limitations on further borrowing and restrictions on selling significant assets. These restrictions may protect the lender but can limit the business’s operational flexibility.
Choosing Loan Terms for Your Business Needs
Here are some tips that can help you choose the best terms for your specific circumstances and needs:
- Loan Amount: Determine the exact amount that you need to borrow. Borrowing more than necessary can lead to unnecessary debt while borrowing too little might not solve your financial needs. Align the loan amount with your business plan and financial projections.
- Interest Rates: The interest rate significantly affects your total repayment amount. Lower rates are preferable, but they often come with stricter eligibility criteria. Additionally, understand the difference between fixed and variable rates to decide which is more manageable for your business.
- Fees and Penalties: Look beyond the interest rate to understand all the costs associated with the loan. Origination or administrative fees, processing fees, and break fees can add up. Understanding these fees will help you calculate the true cost of the loan, especially if you plan on making early repayments or refinancing.
- Repayment Term: Loan terms can range from short-term (a few months) to long-term (up to 30 years). Short-term loans are typically used for immediate operational needs, while long-term loans are suited for substantial investments in your business. Longer terms mean lower monthly payments but more interest over the life of the loan. Choose the term that aligns with your plans and cashflow.
- Repayment Schedule: Know how often you need to make payments (monthly, quarterly, etc.). This should align with your cash flow patterns.
- Security Requirements: Some loans require security. Think about whether you’re willing or able to take this risk. For instance, if you use company equipment as security, defaulting on the loan means also losing your equipment, which can lead to even worse consequences for your business.
- Loan Covenants: Some loans come with covenants or conditions. Ensure you understand these requirements and can meet them throughout the loan term. Consider your business plans and projections before agreeing to these covenants.
