How Are Business Lines of Credit Interest Rates Determined
A small business owner’s job is hard enough but as your cash flow and working capital grow, getting business financing will become a bigger part of your job. Getting a business loan or business line of credit and knowing how interest rates are calculated is important. What is also important is to know what business financing will be available, what lenders will be looking for to approve you, and if you are wasting your time even applying.
I am going to share with you the 25 years of experience I have in dealing with banks, Factors, alternative lenders, and others while I building several small companies.
How Are Interest Rates For Business Loans and Business Lines of Credit Calculated
Interest rates for both loans and lines of credit from banks are almost always based on the market prime rate. The term prime rate will often be detailed in your offer letter if you are approved and will include the prime rate plus additional interest rate points based on your credit risk.
The prime rate changes daily so in the case of a business line of credit, you will be charged the interest based on the prime rate at a specified period of time such as on the 15th of the month on your outstanding balance. The bank will calculate that prime rate and divide it by 365 days to come up with what you will be charged for any outstanding balance on your credit line.
If you have a credit line with a bank, you will only be charged when you have money outstanding but you will also be charged a fee to set up your line along with a yearly maintenance fee. These set up charges are substantial.
In the case of a business term loan, you will lock into your rate at the time of your loan closing date and that rate will not change for the term of the loan. There will be fees (called points) you will pay at closing and if you pay your loan off early, there will be pre-payment penality.
A Business line of credit is most often used for short term cash flow issues were as a business term loan is used for long term capital investments in your business.
How Easy Is It to Get Business Credit
Being approved for business credit is a lot harder to be approved for than many business owners thought it would be. Often times a business owner believes that they have a good profitable business or a great business plan only to find out that banks want two key things when approving business credit. Banks want sellable collateral to back up the loan in case of default and a good personal credit score, often over 680.
As far as collateral, banks will look for equity in your home, stocks, bonds, life insurance, accounts receivables, or any other types of easily sellable assets you own. In order to qualify for an unsecured business line of credit, the bank is going to want to see a lot of cash flow moving through your bank account, a very strong balance sheet, and a 700+ personal credit score. Banks will also sometimes not loan any money in certain industries.
Banks are the most risk-averse financing institutions out there and they basically want to know that if you default on your loan, they have a backup plan to get their money back. It is also very hard to be approved for any type of unsecured line if you have no relationship with the bank already.
Lastly, how well the economy is doing has a big effect on the lending standards of all financial institutions. When the economy is doing really well banks are more open to the idea of providing unsecured lines of credit (business credit) whereas when the economy is poor, banks want more security. There are also other issues such as the recent government restriction on Wells Fargo to limit home equity lines of credit and business lines of credit due to the fraud in opening customer bank accounts without their knowledge.
What is the Loan Application Process Like
The loan application process at a bank is often very long and tedious. The bank will ask for both business and personal information involving lots of questions about the value of your assets. The more information you put on the application the better.
You will also be asked to send over 3 years of business and personal tax returns, up to date income statements, balance sheets, AR/AP reports, bank statements, and other business documents. Contrary to popular opinion, banks don’t care about your business plan.
However, before you even attempt to apply for a business loan, ask the loan officer what the minimum personal credit score will be and what the bank’s collateral requirements are. This will not be the only thing that the underwriters will look at but could save you a lot of time when it comes to filling out the loan application.
If you do move forward with the application, expect it to take 2-4 weeks for you to get a response from the bank. If you have been approved the bank will provide a term sheet with the details of how much you have been approved for and costs. In the case of a revolving line of credit, the offer letter will tell you your credit limit, annual fees, origination fees, and other details.
If you pledged real estate or other collateral there will be an estimate of what the bank wants the property to appraise for and you will be expected to pay for the appraisal.
How a Bank Line of Credit Works
A bank line of credit is often used for short term cash flow issues such as when you have expenses that must be paid like rent, payroll, etc. and when cash flow is down due to your clients not having paid their bills yet. A small business line of credit is perfectly fine to be used for that scenario but what banks don’t like is when your business line of credit indefinitely. In fact, all banks will have a cleanup period term in their conditions which means that you will have to have a credit line balance of zero for a 30 day period.
If you are a new business, the best option is for you to run your business based on existing cash flow. What that means is only spend money on things when you get that money in. As your business grows you will having more business financing options and a longer business credit history.
If you have an outstanding balance on your business credit line, your bank will automatically draw a monthly payment from your business checking account. The interest calculated will be based on the prime rate plus a few points as described in your loan terms and will be calculated based on that number divided by 365 days.
A business term loan works differently in that it is a lump sum of money and the loan amount with a fixed interest rate will be paid back with both principal and interest on a monthly bases. A term loan is most often used for a major investment in a company and often has a much larger loan amount.
How Does The SBA (Small Business Administration) Approve Loans
Contrary to popular thoughts the SBA does not approve business loans directly. The SBA works through traditional banks like Wells Fargo, Bank of America, and other banks. The SBA’s mission is to help small businesses and what the SBA is willing to do is underwrite some of the risks of certain business loans. This allows traditional banks to lower the lending standards to approve more business loans.
The same loan application process that your business would go through with a traditional bank will be the same loan application process you will go through with the SBA. However, with the SBA involved, expects the loan application process to be a lot longer.
The SBA has certain industries that they are more likely to work with so the best thing to do is to talk to a certified SBA approved bank loan officer about your business.
Keep in mind that even the SBA will be looking for collateral and personal guarantees to approve a business loan.
Are Online Lenders Like Kabbage, Ondeck, Bluevine, Financing Solutions a Good Alternative
Online lenders over the last 10 years have become the go-to source for small business loans and small business lines of credit. One of the key reasons is that online lenders tend to not require collateral but will still require a decent credit score. A decent personal credit score for approval is often in the 650 or better category. Anything lower than a 650 you will have to start looking at merchant cash advance companies and those companies tend to be extremely expensive and should be avoided.
Due to the recession caused by Covid-19 public companies like Kabbage, Ondeck and others are not approving any loans or lines of credit because they have lost their funding. These public companies had backing from banks and investors who have since pulled out of supporting these companies.
Private companies like Financing Solutions are still providing business lines of credit because their capital resources have not been compromised.
Financing Solutions, an A+ and 5 stars rated BBB company, has been providing unsecured business lines of credit to small businesses and nonprofits since 2012. The credit line application requirements to be approved include needing $400,000 per year in revenue and a 650 or greater personal credit score.
Financing Solutions small business line of credit costs nothing to set up and nothing when not being used. The only time one is charged is when the credit line is actually used. The credit line is inexpensive when used because it can be paid back at any time and often the line is only used for a short period of time.
One of the key advantages of working with an online lender is that the application process is often super simple and fast. In the case with Financing Solutions, the line of credit application is online and it only takes 2-minutes to fill out. It requires no documentation and there is no credit check run. Once you fill out the online application you will receive an answer the same day along with a simple one-page approval letter.
If you decide to move forward with setting up the credit line, you will be asked for some simple to get documents such as a recent tax return (990 for nonprofits), 4 months of recent bank statements, a driver’s license, voided checks and potentially some other financial statements.
Your business line of credit will then be set up in a secured customer portal and you can request funds at any time. The funds will be wired into your bank account on the day you requested and there will be a small weekly payment required if there is an outstanding balance. You can pay off the credit line at any time by logging into the portal and we will schedule payment from your bank account on that day.
Do Traditional Banks Charge Lower Interest Rates than Online Lenders
A traditional bank business line of credit might not always be the cheapest source of funds for a small business. It really comes down to your capital needs. if you will be using your credit line often then a bank might be the cheapest source for your business. However, if you use your credit line as a cash back up plan then online lenders might be cheaper.
The reason online lenders could be cheaper is that online lenders often do not charge yearly maintenance and set up fees. Combining this with the extensive time it takes to get a credit line set up with a bank, many small business owners have found online lenders a better alternative.