Now that you understand the definitions of the components of a business loan we'll move on to the types
of business loans.
This course focuses on business loans.
I won't be covering personal loans even though many small business owners use personal loans like home
equity lines of credit and I shudder to even think about it personal credit cards to provide funds for
their business.
The approval process for personal loans and how they are structured is very different from business
loans so they aren't included in this course on the basics of business loans what types of loans to
businesses get established businesses have a wide variety of loan and debt options.
Small businesses have much less choices.
In fact they use credit cards as much as they use other lines and loans.
Owners use credit to know that credit cards including personal credit cards are a popular source of
business financing they're an easy source of financing when someone is hungry for money to fund their
business dream.
When owners sign up for and use multiple cards it can seriously hurt their credit score though.
If cash gets a little tight and they start missing payments even bigger damage is inflicted on their
credit score.
Ironically this could prevent them from getting other sources of capital to be more appropriate for
their business.
Credit cards have very high interest rates and fees especially when a payment is missed.
This is easily the most expensive loan you can get another popular reason.
Owners and employees like to use their personal credit cards for business expenses so they can earn
miles or points.
Business accounts payable or accounting departments have to balance an owner and employees desire for
credit card rewards with using company cards that give the business more control reporting and efficiency.
Business credit cards may be tougher to get them personal credit cards for new businesses.
However business credit cards are a convenient way for companies to make purchases especially by multiple
employees.
It may be better to look to them more for their usefulness as a payment method than their appropriateness
as a cash flow tool.
Business lines of credit are an excellent business loan choice for short term cash flow needs you usually
pay an annual commitment fee based on the commitment amount of the loan.
For example if your commitment amount is one hundred thousand dollars and you are charged a 1 percent
commitment fee you would owe 1000 dollars for the ability to use the line which may be advanced from
the line.
Interest is paid monthly based on the sum of the previous month.
Daily principal times the daily interest rate.
Lines of credit usually have a floating rate often with the prime rate as the index.
It may be collateralized by inventory or receivables.
Companies that are stronger financially can get unsecured lines because of their strength of the cash
flow.
I mentioned earlier that the commitment amount of the loan is the maximum amount you can have an outstanding
principal at any time.
The available balance is the commitment amount less any outstanding principal balance.
When you borrow from the line it's called taking an advance or draw on the line.
For example if you took an advance of 1000 dollars the principal balance of the line would go up 1000
dollars and that would be credited to your deposit account at the bank.
Operationally you do this as a transfer from the line to your deposit account via the bank's online
banking system.
The journal entry is a simple debit to cash and credit to loans payable.
You make payments on the line by transferring money from your checking account to the line.
It's very easy business lines are revolving lines of credit.
You can take multiple advances and make multiple payments.
Your commitment amount always stays the same but the available balance decreases with each advance and
rises with each payment.
Let's say your commitment amount is one hundred thousand dollars.
That's also your available balance until you take an advance.
If you take an advance of 1000 dollars your principal balance is 1000 dollars your available balance
is ninety nine thousand dollars and your commitment amount is still one hundred thousand dollars.
If you then make a payment of the 1000 dollars then your principal balance is zero and your available
balance goes back up to one hundred thousand dollars one way lenders ensure that the line is used for
short term needs is by requiring that you periodically rest the line resting the lines means paying
the principal balance down to zero.
How frequent you must do this and how long the principal balance must stay at zero before you can take
advances again is detailed in your loan agreement
lines of credit or for short term working capital needs like inventory payables or payroll.
I know the head of a small company that received monthly financial statements always showed decent cash
balances.
He went to write a check in the middle of the month there was no cash.
The bulk of his revenues were received near the end of the month his month and cash balances were fine.
But he didn't realize how tight cash was mid-month.
He got a line of credit to fix that lines are also used for longer seasonal needs.
I mentioned earlier that I worked at a community bank that served many farmers.
They would draw on their operating lines of credit during the growing season and pay the lines off after
harvest
lines are renewed annually.
The lender will check on the financial health of the borrower during the renewal.
The borrower will need to submit updated financial statements or tax returns to the bank.
For those of you who provide tax audit or financial reporting services your clients will be asking for
these reports to give to the bank one clause in loan agreements to look for that's common in lines of
credit is the due upon demand clause.
This clause allows the lender to call the loan at any time calling the loan means the lender can demand
that the full outstanding balance needs to be immediately paid in full.
This may happen if the borrower's financial situation is worsening.
It may also occur when the lender is weak.
It's used very very rarely but you want to be aware of it during times of extreme stress in the economy
and the financial system.
In the movie It's A Wonderful Life.
George Bailey is about to leave on his honeymoon when Ernie the taxi driver points out that there's
a run on the building and loan that Bailey runs.
The panic was sparked when a bank the building alone worked with called their loan.
The Building and Loan gave all the cash they had to the bank and closed their doors in panic.
George calms the mob and saves the building alone until his uncle almost runs it again.
A fun factoid.
Bert and Ernie from Sesame Street were named for Bert the cop and Ernie the taxi driver I mentioned
from that movie situations like that were more common during the Great Depression than during this most
recent great recession.
What did happen during the Great Recession was that banks reduced the commitment amounts of loans especially
if the borrower never borrowed the maximum commitment amounts because that improved the bank's regulatory
capital ratios.
There's a joke that a banker is someone who's willing to lend you their umbrella when it's sunny but
ask for it back when it starts to rain the dew upon demand clause and reduce commitment amounts are
the realities behind the joke a term loan is a loan where principal and interest are paid on a schedule
based on the term of the loan as opposed to lines where principal is drawn and paid back whenever the
borrower wants equipment loans or term loans with amortization terms of 3 to 10 years and no balloon
term equipment loans are usually fixed rate with consistent PMI payments they're collateralized by the
equipment that's being purchased with the loan funds commercial real estate loans called CRT loans for
short maybe fixed rate or variable rate.
I explained earlier how they can have different repricing balloon and amortization terms they're collateralized
by commercial real estate whereas equipment loans are usually extended when buying equipment.
You can get a CRT loan when buying real estate improving real estate.
We just want longer term loans and have equity in your commercial real estate to borrow from.
It's common for businesses to have more than one loan collateralized by the same property.
Another thing that can happen is for two pieces of property to be collateralized by the same loan.
This is called Cross collateral ization.
Selling one of those properties but not the other while paying off the loan will require approval of
your lender.
You may take out a construction loan if you're building or improving real estate construction loans
have a term of 1 to two years.
They're usually floating rate monthly draws or advances are made on the loan to pay the builder based
on how much construction has been completed since the last payment at the end of the construction period.
The construction loan is converted or refinanced into a commercial real estate loan discussed in the
previous slide.