Beginners guide to small business loans

What are the terms I need to know to compare different small business loans?

Learning the terminology around loans can be confusing at first. Yet, when it boils right down to it, there are only a few really important terms you need to know in order to sift through the mountain of small business loans available. Those terms are as follows:

APR and Interest Rate

APR stands for “annual percentage rate”. It sounds fancy, but it’s basically just the total cost of borrowing money.

You might also see the term interest rate being thrown around. This is simply a multiplier that the lender uses to tack on a finance charge each month. However, the interest rate doesn’t tell the full story when it comes to the cost of the loan. Often, lenders will add on other fees when you take out a loan, such as loan origination fees. These extra fees increase the cost of borrowing money.

In a nutshell, the APR takes into account both the interest rate and the fees to give you one single number. Different lenders charge different interest rates and fees, and this is why a loan’s APR is the best way to compare the cost of different small business loan offers.

How APR Affects a Small Business Loan

Generally, you’ll want to pick a business loan with the lowest APR possible. Let’s look at two hypothetical loans – for the same amount and the same term length, but with different APRs.

In this case, the difference between 5% APR vs. 10% APR means that you’ll save an extra $22.96 each month with the cheaper loan. By the time you’ve paid off the full loan, however, you will have saved a whopping $826.67! What would you do if you had an extra $827 to spend on your small business?

Term Length

“Term length” simply refers to how long your small business loan will last before it’s fully paid off. Generally, it’s better to pick a shorter term length for two reasons.

First, your business will be out of debt sooner. After all, you don’t want your business saddled with debt 30 years down the line. Second, a shorter term length means you’ll pay less in interest costs overall since you won’t be paying interest for as long.

Different Term Lengths on Small Business Loans

To see how this works, consider the two business loans below. They’re identical in every way, except for the fact that one has a term length that’s twice as long as the other:

In the example above, you’d save $806.03 in interest charges over the life of the loan by picking the three-year repayment option. You’d also be out of debt three years sooner.

However, you also have to balance out what your business can realistically afford to pay back each month. Saving $800 and getting out of debt three years sooner sounds like a great plan, however, this also means you will need to pay $138.66 more each month to meet that goal.

It’s a tricky balancing act, and the right answer will depend on your company’s needs and cash flow situation.

Collateral

Many lenders will require you to put up “collateral” as a condition for getting your small business loan. Collateral is simply property — such as your company car, real estate, and office equipment — that you agree to hand over to the lender if your business defaults on the loan.

It’s a way to make the loan less risky for the lender because at least they’re guaranteed to get at something back in return for lending out the money.

Finally, most lenders will allow you to make extra payments so that you can pay off your loan early. Make sure you check with your lender before doing this as some charge prepayment penalties.