How loans work

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Definition

A loan is an amount of money that has been borrowed and must be repaid. Our blog series will help to break down and explain how different types of loans work and how you can decide if loans (debt) or equity is the right choice for you and your startup.
Before you can decide which method is best for you, we are first going to help you understand the important components of a loan and how they can affect your interactions with banks and other lenders.

Important components of a loan

1. Collateral: something of value that ensures the lender is paid back in some manner should the borrower fail to pay back their loan. In order to get a loan, a business must often pledge a security, which will become the property of the bank if the business does not repay their loan.

2. Credit Rating: the history and assessment of an individual’s or corporation’s credit worthiness. It is a score that states how trustworthy you are to borrow money based on your history with borrowing and repaying as well as the amount and availability of current assets and liabilities in your possession. The lower your score, the harder it is to borrow money.

3. Principal: the amount still owed on a loan, separate from interest. This is the amount that the business initially needs to cover their expenses, which is less than the amount that they will eventually have to pay back to the bank.

4. Interest: the additional charge added upon your loan for the privilege of borrowing money. Often expressed as an annual percentage rate, this is the amount of extra money that the business must pay back to the bank, in addition to the original principal that they borrowed. Interest payments are typically made over the duration of the loan.

5. Prime Rate: the interest rate that is given to a bank’s most credit-worthy clients. Also known as the prime lending rate, it is set in relation to the federal funds rate which the overnight rate where banks lend to each other.

6. Promissory note: a traditional signed legal document outlining a loan’s repayment schedule – its formal tone will set loan expectations, as well as encourage borrowers to successfully repay loans.

What lenders look for

The terms of the loan that a bank offers you will be directly related to the information that you give them about yourself and your company. If your loan looks risky, the bank will want a greater return (if they still accept your application), which means you need to put up more collateral or will be charged a higher interest rate. On the other hand, if your loan looks safer, banks will offer you more favorable terms.

1. You: Even though you’re taking out a loan for your business, your personal financial standing gives banks insight into some of the risks they are taking with your business. Banks will look at your credit report as well as your public record to judge your habits for paying bills, any past loan obligations, and other information about your financial history. Your public record shows information involving any legal issues, such as any foreclosures, bankruptcies or legal judgments against you.

2. Your Business’s Financials: Banks will want to see all financial statements related to your business to get a full understanding of what type of loan you need and what kind of stimulations they require. Coming with a prepared and updated business plan will streamline the process as it would include all financial statements completed and laid out. Banks tend to appreciate and reward small business that come prepared and organized to meetings. They will also request projections for the business (classically within the business plan) in addition to a repayment plan. Lastly, they will ask for collateral.