When you’re applying for a business loan, it’s important for you and your lender to communicate efficiently and effectively. Lenders have a whole set of vocabulary you might not have heard before, especially if this is your first time applying for a business loan.
Taking the time to learn some common loan terminology before you apply will not only streamline the process, but also show your lender that you’ve done your research.
Here are some of the most common and important terms you’ll find during the loan application process.
The loan terminology you need to know
From the application itself to your closing paperwork, you’ll run into many of the terms below throughout the loan process. Of course, speaking in the same terminology as your lender will keep your communications efficient, and show that you know what you’re talking about.
These are some of the most common words and phrases for your small business loan:
Conventional lender: When someone refers to a conventional lenders, they’re typically talking about banks. You may have already started a relationship with a bank when you set up your business banking account, so they’re the first lender you should approach when you need financing. Banks also tend to offer the lowest interest rates, but may have more strict requirements to qualify for their products.
Alternative lenders: Alternative lenders include a wide variety of funding sources. Community Development Financial Institutions (CDFIs) fall under this category, as well as credit unions. It also includes online lenders. While some responsible alternative lenders offer an online application process, you’ll want to be careful that you’re not working with a predatory online lender.
There are many alternative lenders that offer Small Business Administration (SBA) loan programs that have many advantages for borrowers. They offer competitive interest rates and longer repayment terms that keep more money in your business and can even unlock complimentary advisory services to support your goals.
Criteria: Every lender will have specific requirements for a borrower to qualify for their loans. This is their qualification criteria. They might need a minimum credit score, proof of income, and business financials to determine if you’re a good fit for their products.
Conventional lenders tend to have more strict criteria requirements, while alternative lenders can be more flexible. Ask potential lenders what they require before you apply, and it’ll show that you’re proactively preparing for the loan application process.
Five “C’s” of Credit: When you submit your loan application, the lender’s underwriting department will review these five areas to make a decision. The five C’s are:
- Character: This is determined by your personal credit score and history. Some lenders have the flexibility to look beyond the numbers of your credit score and dig into the “why” behind them. What they find will also be part of their assessment of your character.
- Capacity: This is your ability to pay back your loan in addition to any other debt. Your lender will usually calculate your debt service coverage ratio (DSCR) to see if you have enough cash to pay your debts. They’ll look at your business’s financial statements and calculate how much of its net operating income is taken up by your current debt and expenses.
- Collateral: For most loans, a lender will ask you to pledge collateral to secure your loan. These are physical assets owned by you and your business that the lender can use to get back any losses if you don’t pay back your loan.
- Capital: This is savings and other assets that can be claimed by the bank in repayment if you default on your loan.
- Conditions: This is how you plan to use your loan, your loan amount, and the current interest rates being offered.
Loan principal: The loan principal is the amount of money that’s borrowed before interest and any additional fees are added. Let’s say you need a business loan for $30,000 for working capital, then that amount ($30,000) is the loan principal.
The amount you pay toward your loan each month will include a portion of the loan principal, but it also includes a portion of the interest on the loan and fees.
Interest rate: The interest rate on a loan is the amount that a lender charges a borrower for borrowing funds. Interest rates for a loan can be fixed or variable:
- Fixed-rate loan: With a fixed-rate loan, the interest rate is the same over the life of the loan, no matter what happens to interest rates outside of the loan. This can have several advantages. Fixed-rate loans can be beneficial when rates are lower because they lock in a lower rate until the loan is paid in full.
Fixed-rate loans also make it easier for you to create a budget because your monthly payment won’t change over time. And, if interest rates do go down, then you may have the opportunity to refinance your higher-rate loan to one with a lower rate.
- Variable-rate loan: With a variable-rate loan, the interest rate can change throughout the life of the loan. While variable-rate loans often have an enticing introductory rate, the interest rates on these loans can increase significantly over the life of the loan. For example, during a period of inflation interest rates set by the US Federal Reserve tend to rise to help get inflation in check, and interest rates on variable-rate loans will rise, too. This often leads to higher payments and makes it harder to budget for your business.
Annual percentage rate (APR): When you’re shopping for loans, you’re likely comparing interest rates between your options. Of course, the rate itself is important, but the best way to compare loan products is the APR.
The APR will give you the most accurate picture of what the loan will actually cost. This is because it also includes any fees (such as application fees, closing costs, and any other expenses or fees that are part of your loan) that are rolled into the overall cost of the loan as well as the repayment time.
So if you’re looking at a loan with a lower interest rate that includes higher fees and a shorter repayment period, its APR will be much higher. On the other hand, a loan with a higher interest rate but lower fees and a longer repayment period will have a lower APR.
Repayment period: A repayment period is the amount of time that you’re going to pay back the principal, interest, and any fees for a loan.
Your repayment period makes a big difference in your monthly payments. Reputable lenders will offer a reasonable repayment period that makes it easier for you to repay the loan. Conversely, predatory lenders will make loans with repayment periods that can be extremely challenging for you to fulfill. For example, a $10,000 working capital loan with a repayment period of five years is going to be much easier for you to repay than the same loan with a repayment period of six months or one year.
Make sure you know what repayment period you’re agreeing to when you sign your closing documents so you can successfully pay off your loan on time.
Balloon payment: A balloon payment is the unpaid remainder of the loan that’s due at the end of a repayment period. You’ll find a balloon payment if you’re signing for a loan that isn’t fully amortized over the lifetime of the loan. That means that the loan is set up to only repay a portion of it before the end of the repayment period.
For example, sometimes a loan will be structured for you to make interest-only payments for the repayment period, and when that period ends, you’ll have to pay back all outstanding principal and any interest or fees that are still owed.
Balloon payments may also be included when a loan is amortized over a longer period to reduce the amount of a monthly payment, but the actual repayment period is shorter.
For example, a loan may be amortized over 10 years, but the actual repayment period may be five years with a balloon payment at the end. This gives you a lower monthly payment over the five-year repayment period. Once you reach the end of that period, you’ll have to pay back all the remaining principal, interest and fees in one payment.
Average monthly payment obligation: Your average monthly payment obligation is the payment amount that you’ll be required to pay every month. You’ll discuss this with your lender ahead of time, and it’s included in your loan’s closing documentation. This amount won’t include any additional charges or fees, however, you should be aware that fees outside of your monthly payment obligation (such as late fees) may be charged as part of your loan agreement and when needed.
Default: Defaulting on a loan means you haven’t paid back the amount you owe as you agreed to at closing. Both you and your lender want to avoid this situation. If you default on your loan, your lender can claim any collateral that you pledged or take other steps to reduce their losses.
Your loan agreement should include details about what counts as a default. In some cases, missing just one or two payments may be enough to trigger a default on your loan.
Given the negative impacts on both parties, a reputable lender will always encourage you to contact them if you’re having trouble making payments on time, in full, and otherwise as agreed. Often, they’ll work with you to negotiate temporary or long-term solutions that will help ease repayment challenges without damaging your business or your lending relationship.
Speaking the same language as your lender will show them that you understand the process and your responsibilities as a borrower, increasing their confidence in you. It can also help you spot the warning signs of a predatory lender and protect your business against a loan that could jeopardize your future.
Pursuit has more than 15 loan options with great terms for small businesses
Pursuit helps small business owners like you in New York, New Jersey, Connecticut, and Pennsylvania get the financing you need to keep your business growing. With more than 15 loan options available, we can help you find funding that fits your business’s needs. Take a look, then contact us today to learn how we can help you keep your business moving forward.