10 Business Loan Terms Every Entrepreneur Should Know
As a small business owner, you need to come armed with an unexpected toolkit
As a small business owner looking to get the best possible loan for your business, you'll need to come armed with an unexpected toolkit – a strong knowledge of common business loan terms. That's because industry jargon that lenders use can definitely be confusing, especially if you haven't gone through the business loan process before.
For example, if you don't totally understand the difference between annual percentage rate (APR) and interest rate, you could choose a loan that's actually more expensive. You could also end up paying more if you don't know about origination fees and finance charges, and opt for the loan with a slightly lower interest rate but don't add in these costs, too.
So, although business loan terms might seem like jargon, understanding them will unlock meaning that’s vital to getting the very best loan for your business. And, in the end, save you money—what every business owner is ultimately looking for.
Here are 10 key terms you’ll want to know in and out before applying for a small business loan:
1. FIXED + VARIABLE INTEREST RATES
Interest rates should be one of your top considerations when shopping for a business loan. Your interest rate can either be fixed, in which the rate remains the same over the entire loan term. It can also be variable, aka the rate fluctuates as market rates change, just as you might think.
Fixed interest rates remove the question of whether your loan will get more expensive over time. Plus, experts do advise to choose a fixed interest rate if market rates are low. That way, you can lock in a low rate.
If market interest rates are generally high when you apply for a loan, you may want to go with a variable interest rate. That way, if rates go down, your payments will lower thanks to a decreased interest rate. That said, variable rates are a gamble—if interest rates go up instead of down, you'll have to pay an increased rate, too.
2. ANNUAL PERCENTAGE RATE (APR)
The APR is one of the most important things to look at when searching for a business loan. It’s a percentage that indicates the total cost of your loan, figuring in interest rates, closing fees, and any other charges. Since this number takes into account fees including the interest expense, it’s almost always higher than the interest rate.
The APR is the most precise measurement of how much the loan will cost your business. Always run the numbers to see what a loan’s APR will end up being. It’s usually a quarter to half a point higher than the interest rate but can be much higher if fees are high. A lower APR is always better.
Collateral is something you offer up to the lender to mitigate the risk they take on by lending to your business. If you’re unable to repay the loan, the lender will be able to seize whatever you offered up for collateral until they recoup the value of the loan. Collateral can be business assets like real estate, equipment, vehicles, cash, etc. In some cases, lenders can ask for carte blanche to seize anything in case of default—this is called a “blanket lien.”
Some loans, including equipment loans and invoice financing, have collateral built right into them. In that case, the lender would seize the exact thing that the borrower will be financing with the loan in case the borrower defaults.
Although putting up collateral might seem risky, note that you’re more likely to qualify for favorable loan terms when you can secure the loan with collateral. In fact, many banks and financial institutions that offer traditional term loans require some form of collateral.
4. DEBT-SERVICE COVERAGE RATIO (DCSR)
Since risk is always top of mine for lenders, the main thing they’ll want to check is if your business will be able to make loan payments on time and in full. One way they determine that is by calculating your debt-service coverage ratio (DCSR). This measures how much cash you have available to service a debt.
Calculate your DCSR by taking your net operating income and dividing it by the total amount of debt you have. If your DCSR is 1 or higher, lenders will typically consider that favorable (though some lenders may want to see it above 1.1 or 1.15).
5. PROFIT + LOSS STATEMENT (P&L)
Nearly every lender will want to see some form financial documentation for your business loan application. One of the most common they’ll ask for is a profit and loss (P&L) statement (also called an income statement).
A P&L statement is a detailed document that shows your company’s income and expenses over a quarter or year. If you’re not already tracking your small business’s finances to the letter, there’s no better time than now to start keeping thorough, precise records through your P&L. Lenders will need it to get a clear sense of your company’s financial health, and to get a sense of any net profit.
6. CASH FLOW STATEMENT
A cash flow statement shows cash outflows and inflows during a certain period of time. You may think of a cash flow statement as synonymous to an income statement. Regardless, your income statement may factor in outstanding client invoices, while a cash flow statement wouldn’t (because the money hasn’t reached your business yet).
So, for many lenders, a cash flow statement provides important information into the financial health and flexibility of your business. For example, you can be profitable but cash flow negative if customers are paying you slowly—and that may lead to less favorable rates and terms on your loan.
7. BUSINESS CREDIT SCORE
Your business credit score is a number that indicates your company's borrowing history. It’s different than your personal credit score—but functions much in the same way, taking into account your company’s repayment track record, current debt obligations, how long you’ve operated, any legal filings (like a bankruptcy), and more.
If you want to find out your company’s business credit score, you can look it up with one of the three credit bureaus that score companies: Experian, Dun and Bradstreet, or Equifax. If your business doesn’t have a long credit history (or have one at all, which is possible if you’re a startup or new business), lenders will likely scrutinize your personal credit score in addition or instead.
In the context of a business loan, this term is the amount of money you’re borrowing, not including the interest charges or any other fees tied to the loan. Even once you’ve started accruing interest on any money you’ve borrowed, you can always think of the principal as the original loan amount.
For example, if you get a small business loan from a bank for $200,000, then your principal is always $200,000. The more you pay off the principal each month, the quicker you’ll repay the loan.
9. FACTOR RATE
You may encounter a factor rate if you’re looking for quick-turn-around financing. A factor rate is a number rather than a percentage. Factor rates usually fall between 1.1 and 1.5.
To figure out how much you’ll pay back in total for your business financing, you multiply your principal debt by your factor rate. That’ll allow you to calculate the amount much to pay back in total.
For example, if you borrow $50,000 at a factor rate of 1.2, you’ll be expected to repay $60,000 in total.
Before taking out a short-term loan with a factor rate, like a merchant cash advance, calculate the APR. If your short-term financing comes with a factor rate, the amount of interest you end up paying back can be quite costly.
Amortization refers to the way in which a borrower repays a loan. Typically, the lender will give you an amortization schedule, which is a chart that details how much comes off the principal and how much goes to interest and other charges with each scheduled loan payment.
If you plan to pay off the loan as fast as possible, check whether there’s a prepayment penalty before you agree to terms. Some lenders assess a prepayment charge to make up for money lost on the interest that the borrower avoids by repaying ahead of schedule.
LEARN ALL YOU CAN TO FIND THE BEST LOAN FOR YOUR BUSINESS
Although this doesn’t include every single term you’ll encounter while researching and applying for loans, now you know some of the most important ones. Use your resources throughout the loan application process so that you’re absolutely clear on every term and acronym that a lender throws at you.
By doing your due diligence, you can steer clear of expensive, unfair loans and go straight for financing that suits your company’s objectives and needs.
Meredith Turits is the managing editor at Fundera, an online marketplace for small business financing. Drawing on her own background in small business and startup experience, she writes on business, finance, and entrepreneurship.