Applying for a loan is one of the most important steps that you’ll take as a small business owner. To give yourself the best odds of approval, it’s important to thoroughly prepare for the process.
An easy step that’s often overlooked is to become familiar with the terminology that lenders commonly use. Speaking the same language as your lender demonstrates that you understand the process and your responsibilities, increasing your lender’s confidence in you. This can also help you spot warning signs that a potential lender may not have the experience you need or may demonstrate predatory-lending behaviors—either of which can result in a loan that’s poorly structured, with repayment terms that jeopardize your business’s cash flow.
Common terminology to know when choosing a lender
As you’re considering potential lenders, know that there are conventional lenders and alternative lenders.
Conventional lenders are banks. They’re often the first lenders that you’ll approach because you’ll already have an account with one (or more), and they tend to offer the lowest interest rates.
Alternative lenders include other types of community and institutional lenders, such as community development financial institutions (CDFIs) like Pursuit and credit unions, and a wide range of online lenders including peer-to-peer lending networks. While non-profit, mission-drive CDFIs are certified and reliable, some alternative lenders offer predatory loans that can be damaging to small businesses, so proceed with caution and only use reputable sources.
Every organization that makes loans will have specific things that are required from the borrower, such as minimum credit scores, proof of income and business financials. You may hear this referred to as a lender’s criteria. By asking potential lenders what they require, you’ll show that you’re proactively preparing for the process.
The interest rates and annual percentage rates (APRs) that lenders charge also vary. The interest rate reflects only the interest charged on a loan, while the APR also includes upfront and other loan fees. For that reason, loan payments calculated using the APR provide a more accurate estimate of the total cost of a loan over time.
Common terminology during the application and approval processes
When you apply for a loan, your loan officer is the person you meet with, but it’s the underwriter who will analyze your financial information and determine if the loan is approved or declined. The review of your application and supplemental information against predetermined lending criteria is called the underwriting process.
The underwriter will consider any or all of the “Five Cs of Credit,” a set of criteria that most lenders use as a basis for decisions. They include:
- Character, which is determined by your credit score and history;
- Your capacity to pay back the loan, based on your income and other financial obligations;
- Collateral (when applying for secured loans);
- Capital, such as savings or assets that can be claimed by the bank if you don’t make your payments; and
- Conditions—primarily, how you intend to use the money.
Lenders can’t afford to make loans to borrowers who won’t be able to pay back the loan. That’s why capacity is so important. Your capacity shows that your business will bring in enough money to cover the costs of the loan, as well as any other outstanding financial obligations.
Lenders will determine your financial capacity using a calculation called a “debt-service coverage ratio” or DSCR. Typically, it’s a year of your business’s net operating income, divided by a year of your business’s total debt service. Earnings before interest, depreciation and amortization, or EBIDA, is another calculation that underwriters may use to determine your business’s capacity.
To calculate DSCR or EBIDA, an underwriter will review your company’s financial statements. Financial statements include an income statement (or profit-and-loss, with both income and expenses), cash flow statement and balance sheet.
Key takeaway: Preparation is essential to success
By learning common lending terminology, you’ll increase your financial knowledge and demonstrate to your loan officer that you understand the responsibilities of borrowing, which can help improve your chances of approval. It’s a great investment of time in your business knowledge and future success.
