There's more to a loan than paying your monthly installment. Look for these hidden terms and fees a lender might include in a loan agreement.
- Lenders analyze factors like income, debt-to-income ratio, credit score and collateral to determine whether to extend funding to a borrower.
- Different lenders offer different terms. Watch for hidden terms and fees that could end up costing you more.
- Prepayment penalties, yield maintenance fees, origination fees and points are some of the terms you should look out for.
- Always have an attorney and/or accountant review the loan agreement before signing.
Business loans are often an important part of launching and growing a small business. However, it can be easy to get in serious trouble when taking on debt. Some lenders may include terms and hidden fees in loan agreements that cause debt to balloon and could put your business in serious financial trouble.
By closely reviewing loan agreements a lender offers (along with having a professional attorney and accountant review them) you can arm yourself against an unfair repayment program. Know your loan repayment options and when it's time to seek funding elsewhere. This guide will introduce you to the concept of business loans, as well as some hidden terms and fees to look for.
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How does business loan repayment work?
So you need a business loan. The process begins with a loan application, generally submitted to a bank, credit union or private lender. The lender then considers the borrower's application, often assessing factors like income, credit score, cash flow, cash reserves and collateral, when applicable. Based on these factors, a lender might approve a borrower's application and extend a certain set of terms: a lender offers X dollars at Y interest rate over Z months or years.
"Once funds from an approved loan are disbursed, interest begins to accrue immediately and is usually expected to be paid monthly," said Larry Fuschino, owner of Raider Consulting. "Principal of the loan is to be repaid based on the terms of the loan, which can vary with each situation and borrower. However, these terms will be disclosed in the documentation provided by the lender."
There is more to it than that. In addition to the principal, interest rate and repayment term, many lenders include other fees and terms in their loan agreements. For entrepreneurs, it is crucial to understand every aspect of the agreement before accepting a loan, as they can sometimes contain hidden gotchas that balloon into significant expenses.
"I'd advise other small business owners to comb the repayment terms … Better yet, have a professional look over everything," said Jesse Silkoff, founder of MyRoofingPal. "While you may be using a reputable lender, it never hurts to make sure you're getting a fair deal. Don't let a lender exploit the fact that you need this loan. There are always other options out there if they aren't willing to give you fair terms."
What is a loan repayment term?
One of the most important elements of a loan is the repayment term, which is the amount of time you can expect it to take to fully repay the loan debt and the interest associated with it. In some cases, the loan can be repaid before it reaches maturity; in other cases, loan borrowers face a steep penalty for doing so.
"The repayment term is also known as the loan period, or the duration of time over which the borrower will complete repayment of the loan to the lender," said Jared Weitz, founder and CEO of United Capital Source.
The terms can vary depending on the nature of the loan you are taking out. However, understanding the repayment term and whether you have the option to repay the debt early without penalty is a key element to determining whether or not a business loan is right for you.
How long can you finance a business loan?
Whether you need a long- or short-term business loan, there is likely a financing option out there that suits your business. Conventional business loans tend to have longer repayment terms and lower interest rates, while short-term loans often come with higher interest rates.
It also depends on your financing partner. Conventional lenders like banks and credit unions, for example, will likely have different types of business loans available than private lenders, who are generally more flexible but also more expensive.
"The term of a business loan is usually matched to the underlying reason for it," Fuschino said." If a business needs to buy a new warehouse, the term of the loan could be five to 15 years. If the business needs to buy extra inventory to be sold during the next season, the lender may only allow a three- to six-month term."
Some business loans have even longer repayment terms, stretching to 25 or 30 years, much like a home mortgage. Before committing to a long-term loan, have a plan in place to meet the monthly payments. A loan is a big commitment and, while the funding might be necessary to grow your business successfully, it should never be taken lightly.
Is a loan repayment tax-deductible?
Many entrepreneurs wonder if loan repayments are tax-deductible. To many small business owners, loan payments feel like a business expense. While you can deduct interest payments from your taxes (interest is, after all, the cost of borrowed money,) the principal value of the loan is not deductible.
"The interest paid on the loan is usually considered an accounting expense. It is usually a tax-deductible expense as well, but be sure to discuss this with your accountant [or] tax preparer," Fuschino said. "Principal payments are a cash outflow but [are] not considered an accounting or tax expense."
Repayment terms that may be hidden in a business loan
The terms you'll come across in a loan agreement can sometimes be vague and confusing. What passes as common terminology for many lenders, may be inaccessible jargon to many entrepreneurs. When you need money quickly, it can be difficult to read between the lines, but the devil is in the details. Keep an eye out for the loan repayment terms listed below, which could result in you spending more money for a loan.
Prepayment fees are a notorious gotcha that appears in many business loans. A prepayment fee is incurred if a loan borrower pays off the outstanding balance of a loan prior to the loan's maturity date. Prepayment fees reimburse the lender for lost interest when a borrower pays the loan back early.
"When a loan is paid prior to the repayment period, there is the chance the lender will charge a … fee," Weitz said. "Read through all loan documentation prior to signing to understand whether this fee would be applied in the event you wish to pay off the loan prior to the scheduled completion date."
If possible, avoid taking a business loan that charges a prepayment fee.
Yield maintenance fees
A yield maintenance fee is similar to a prepayment fee. Yield maintenance fees are specific to commercial real estate prepayment fees and can vary depending on several factors.
"Yield maintenance fees are a complex calculation that banks have to calculate for borrowers," said Rob Stephens, founder of CFO Perspective. "Yield maintenance fees are calculated as the difference between the total interest you owe on the remaining term of your current loan and what the bank can earn at current loan rates."
Yield maintenance fees are difficult to get waived, even if you refinance your loan, so carefully consider your options before accepting a loan with a yield maintenance fee.
Some lenders might build "origination fees" into your loan. These fees are designed to cover the costs involved in processing your loan application. These fees comprise a series of multiple charges related to the underwriting of your loan, the processing of your application and the application itself.
You might also encounter a "fee" that is referred to as "points." Points are essentially an additional percentage of the value of the loan paid above and beyond interest and other fees. Often, points are paid at the end of a loan term. If a lender charges one point on a $100 loan, for example, that equals an additional $1 due on top of the principal and interest payments repaid during the term of the loan.
"Something to remember is that consumer protection regulations at the federal and state level often do not apply to business-to-business transactions," Fuschino said. "Business owners are expected to be sophisticated and able to understand issues and negotiate with lenders as necessary. While online lenders may not negotiate their 'one-size-fits-all' process, business owners may have more success with local lenders."
If you are curious about what additional terms and fees are included in your loan, consult the Loan Estimate and Closing Disclosure. This document contains a detailed breakdown of all costs associated with the loan. It is best to have a professional attorney and accountant review this document before signing the agreement.
Be careful when accepting a business loan
When accepting a loan, it's important to ensure you will make payments on time. Never take on debt that you can't service. However, it's also important to be sure you're getting a fair deal. Just because a lender is extending funding to your business doesn't mean they're doing so on fair terms. There is more to a loan than paying the monthly installments – closely review any loan agreement you sign.