Lending is an essential part of growing any business. Whether you are starting a new venture or looking to expand your client offering, sometime an injection of cash is needed to take your company to the next level. However, with so many different options, it can sometimes be an overwhelming process. Here’s our guide to some of the most common forms of lending.
Overdraft
An overdraft is a line of credit which is essentially an extension of your existing bank account, allowing you to spend beyond your balance on this particular account. An overdraft limit will be agreed with your bank, and once this is in place you will be able to withdraw funds up to that limit.
Business overdrafts can be easy to arrange and as soon as the facility is agreed you will have access to the extra credit. This can be an ideal solution for short-term lending needs, or if you are having unexpected cash flow issues. Unlike some other loans, there is no charge for paying off your overdraft earlier than expected and you do not have to sacrifice shares in the business, or put your assets at risk, to secure the funding.
However, there are some considerations to make when extending your overdraft. Interest is charged on a daily basis and currently interest rates for overdrafts are some of the highest on the market at 14.1% EAR. Whilst there is no minimum monthly repayment, remaining in your overdraft for a considerable amount of time can affect your credit score and opportunities for future lending.
Loan Against Property
Loan Against Property (LAP) also known as Secured Loans, are loans taken against the mortgage of your property. To be considered for this loan you will have to own your property.
The main reason for considering an LAP is requiring a significant amount of money (over £20,000), that may be difficult to access from other lines of credit, such as an overdraft. LAPs are appealing as they have comparatively low interest rates and also offer longer repayment terms. A LAP may also be a good option for those who have a poor credit rating, as with your property as a guarantee, there is less risk for the lender. However, having poor credit rating is likely to limit the amount you can borrow and may also mean a higher interest rate.
The biggest risk you are taking with a LAP is that your property or asset is controlled by the bank once the loan is in place. If you are struggling with repayments, this could mean that the property is seized until the debt is settled, and could be sold in extreme cases. Whilst all debt can have negative effects, losing your home can be devastating for yourself, and your family, so this line of credit should be approached with some caution.
Payday Loans
These loans may seem like a good option, or potentially the only option, if you have a bad credit score, limited financial security and need almost instant access to funds in case of an emergency. These loans can be applied for and approved within the hour, making them a very tempting option for situations where you need extra money fast.
However, payday loans come with an incredibly high interest rate and failure to repay the loan quickly can lead to the individual becoming sucked into a cycle of debt that is difficult to recover from. For example, if you borrowed £250 for 3 months, with an interest rate p/a of 292% (a common rate among payday loans) if you paid it back in 3 repayments, each one would be £137.21, meaning the total you would repay is £411.63 – almost double what your originally borrowed. Often, individuals are unable to make their monthly repayments and the debt rolls over to the next month with added interest. Once this starts to happen the debt can become unmanageable and impossible to get out of without another form of lending.
Revolving Line of Credit
Sitting somewhere between a credit card and a bank loan, is what is known as a ‘revolving line of credit’ – also known as a Working Capital Loan. Unlike bank loans, a revolving line of credit do not have to be deposited to you in full in one lump sum. You can access funds up to your agreed limit, as often as you need, and can pay it back in flexible monthly repayments. Once the funds are replenished they are once again available for you to access.
Small businesses may choose a revolving line of credit over a credit card, as once accessed these funds will be available directly from your bank account. This can be useful for situations such as paying employees, as you can pay them through payroll as normal rather than asking them to accept payment through credit card.
Whilst a revolving line of credit can be easy to set up, they are harder to secure for individuals with a poor credit rating, or a new business. The temptation to spend more than you can afford to repay is quite high with these easy access funds, so close monitoring is essential.
Business Bank Loans
One of the most secure forms of lending is a bank loan. A bank loan, also known as a long term loan, is a sum of money borrowed over a set period of time with an agreed repayment schedule. With these loans you can borrow a substantial amount money in one go and repayment amount will be relative to the size of the loan, the agreed interest rate and the duration of the lending period.
There are a number of advantages of bank loans that makes them ideal for small business. Interest rates may be fixed for the term, which makes it easier to forecast interest payments and organise your finances. There is also no need to give up a share of your business to the bank to secure the loan. Having, and regularly repaying, a bank loan also allows your to build up a good credit score which can be useful for future lending and these accounts can be verified by lenders against your tax return and other proof of finances, giving a complete picture of your businesses financial situation.
There are a wide range of loans and lenders on the market, so you are like to find one that suits your businesses’ needs and situation. CreditEnable can help you find the right lender for you.
Interest Rates
As well as understanding the different options of lending, it is important to familiarise yourself with the different kinds of interest rates.
Interest is effectively the cost of borrowing money. When you take out a loan, use and overdraft or have a credit card, the money you pay back on to of the initial amount borrowed is the interest.
Standard Interest vs Compound Interest
Standard Interest – also known as Simple Interest or Nominal Interest – is based purely on the original loan amount.
For example, if you were to borrow $1,000 at 3% interest per annum, after a year you would owe $1,030. If the loan was taken out over a period of 3 years, by the end of the 3 years you would owe $1090.
With compound interest, it is a little more complex. When interest is compounded it is calculated based on and added to the new amount rather than the original loan amount. Taking the example above, if you were to borrow $1,000 at 3% compound interest over 3 years, that would look like this:
Original Principal Amount= $1,000
Interest after Year 1 = (3/100) x 1,000 = $30
Principal after Year 1 = $1030
Interest After Year 2 = (3/100) x 1030 = $30.90
Principal Year 2 = $1060.90
Interest After Year 3 = (3/100) x 1060.90 = $31.83
Principal After Year 3 = $1,092.73
The difference may not seem like much in this example, but with larger loan amounts and over longer periods of time, the difference accumulates to be quite substantial.