A conventional loan is any mortgage that is not guaranteed or insured by the federal government. These loans were the first loans made by local lenders. Conventional loans were held in the lender’s investment portfolio until they were either paid in full or foreclosed upon. This practice allowed lenders to build a business relationship with the borrowers. Problems arose when interest rates began to rise and lenders began to see below market returns and were unable to use these investments to turn around and sell to other borrowers.
In the late 1930’s, a secondary market was created, and lenders were able to sell the loan packages to this secondary market. This then allowed them to loan out their funds to more borrowers. This is how most lenders practice their business today.
When a business owner is looking for a loan they have a couple main options: conventional loans and SBA loans. Listed below are some of the major pros of conventional loans:
- Lenders have the ability to keep the loan in their own portfolio, thus preventing the loan from having to meet secondary market guidelines.
- Lenders will sometimes eliminate loan fees for the convenience of the borrower.
- Collateral other than or in addition to real property may be accepted by a lender.
- Loans held in lenders’ portfolios do not have to meet appraisal standards of the secondary market or those of other loans.
- In the event of a borrower failing to qualify for Private Mortgage Insurance, lenders may self-insure the loan (interest rate will rise in order to compensate for the greater risk.
- Lenders may create different financing options for the borrower if it is held in the lenders portfolio.
On the other hand, conventional loans also have numerous disadvantages:
- Conventional loans usually require a larger down payment than SBA loans.
- Interest rates are set by the lender, and can exceed rates of the other two.
- Lenders also determine origination fees as well as other costs associated with the loan.
- Loan documents held by the lender can always vary, and lenders may add certain clauses in the contract.
- When a loan has a loan-to-value ratio of more than 80%, borrowers must purchase Private Mortgage Insurance.
- Many lenders will charge fees to simply file an application.
Since the majority of conventional loans are sold on the secondary market, the guidelines associated with this market have been generally accepted.
Comparison of Conventional and SBA Loans
SBA loans include larger loan amounts and longer terms as opposed to conventional loans. These loans also have competitive interest rates along with no balloon payments or annual reviews.
And all SBA loans are fully amortized. To understand the benefits of full amortization, consider a loan that is used to purchase commercial real estate.
The conventional bank loan is normally amortized over 15 to 20 years and renewed every 3 or 5 years. So, when a small business owner faces the 3 year review of that conventional loan:
- The bank may decide that its risk appetite no longer favors loans for those types of businesses and therefore requires full payment.
- The bank may review and re-amortize the loan over another 15 to 20 year period which would mean more interest over the term of the loan.
- If the small business is doing well, the bank may renew the loan as is, but often the borrower must still pay thousands of dollars in costs associated with the renewed loan application.
The uncertainty and additional expenses for refinancing or restructuring a loan with conventional loans are eliminated with SBA loans, as rates are locked in for the 25 years with no annual reviews or balloon payments. When dealing with small businesses, cash flow may be a major concern. If this is the case, SBA loans may fit better for long-term financing. Terms for SBA loans usually last between 7 and 25 years fully amortized. SBA guaranteed loans are made by private lenders, but guaranteed by the SBA with funds given by Congress. On average, the SBA guarantees over $10 Billion per year.
Loan Criteria Qualification
Loans are the single most used source of funding. Before applying for a loan, one should have a brief understanding of what lenders or banks will be looking for. There are many different things that go into qualifying for a loan. When you first apply for a loan, the bank or lender will examine three main points about you (the borrower).
1. Ability to repay a loan. If a lender is going to lend large amounts of money out to a small business owner, they want to be sure that the borrower will be able to repay the loan. Several criteria are used to determine this. Lenders often take a look at your cash flow to determine the amount of loan you applied for will be plausible for you take pay back. Credit scores are also looked at to examine if you’ve paid of past credit cards and other loans, whether or not your past payments have been on time, and to see if you’ve defaulted any creditors. One factor that helps when applying for a business loan is that lenders prefer to lend to business that have proven the test of time and have gained high profit consistently.
2. Credit History. Perhaps one of the biggest factors lenders look at when one is applying for a loan is credit history. Using Experian, Equifax, TransUnion, or another small credit bureau, a lender will pull a credit report and examine the borrowers past history. It is important that before you go into apply for a loan that you make sure that your credit score is high enough. You are able to get a copy of your credit report before hand to make sure of this. Another thing to be wary of identity theft. On your credit report make sure that your name, address, and social security number are all correct. Identity theft is an increasing problem and can cause your credit score to be extremely low. When qualifying for a loan, being honest can help you. If your credit scores aren’t as high as they should be because of an unfortunate event such as a medical crisis, job loss, etc. explain this to your lender and they may be willing to help you. Bringing along written information explaining circumstances that have hindered your credit score can help you.
3. Equity. It is very common for a lender to ask for equity or collateral whenever you are applying for a business loan. Sometimes the building itself can be the collateral and equity can be built by offering the lender a down payment. Be prepared to offer equity when applying for a loan, it is a very common thing for lenders to do despite your credit score.
What are the steps to apply for a loan?
Obtaining a loan can be tough. It is important to have a plan before you go and see a bank or a lender. Having a plan will prepare you to sell your business to the lender and help you get a loan. There are seven main steps needed when applying for a loan, they are: (1)
1. Decide how much money your business needs. It is important to calculate a figure that represents your business’ initial costs. It can be easy to under estimate your business costs (particularly start up costs). This is because business owners make the mistake of only evaluating your initial costs and not including the first year’s working capital as well. On the other hand though, some business owners can completely overestimate their costs. This can be more harming to the applicant because the lender will begin to question the applicant’s intentions and whether or not they have the experience or knowledge to own their own business.
Loans that are $25,000 or smaller are considered small, micro loans. Many banks are not interested in loans this small. However, there are Micro lenders, credit unions, Alternative lenders who are better suited to handle this type of loans. If you are an existing business, you have to show your previous years’ tax documents and have to been in business for at least 2 years.
2. Find out your credit score. Before you apply for a loan you should check your credit score to make sure it is good enough. A credit score from 650-680 is usually considered good, and a score in the 700’s is considered very good. The higher your credit score is means the higher your chances of getting a loan.
3. Research your options. It is important especially if you are uncertain about applying for a loan, to have a wide breadth of options. Some options to consider are getting a co signer, using a partner with a good credit score, or even investing more cash into the business. A strong applicant will present these ideas to the lender if needed in order to obtain the loan.
4. Write a business plan. It is important when applying for a loan that you come prepared with a detailed business plan. This business plan should be able to show the lender your every move in how you plan to be successful in your business. Elements your business plan should include are your product or service, sales forecasts, and a 1 year (month by month) cash flow, 3 years income statement, a balance sheet, a statement of sources, uses of funds, and an amortization schedule. In addition to getting a loan this can be a tool to help you evaluate your business concept as well as attract partners or investors too.
5. Find a lender. Finding the right lender can be difficult. There are many different options to look for when deciding which type of lender is right for you.
a. Commercial banks generally only accept loan applicants with high credit scores (700+). They also tend to like applicants with a strong personal financial situation to analyze the net worth. If you are applying for a loan that is greater than $50,000 the bank will require collateral (home equity, savings, etc). Some commercial banks do not require a business plan if you applying for a small loan.
b. Non-Bank lenders do not participate in consumer banking; only business loans and services. Non-Bank lenders tend to serve to specific industries and will often to accept loan applications that commercial banks find too risky as they are generally more flexible with low credit scores.
c. Region specific lenders are neighborhood lenders who are usually provide very flexible loan terms. It is often that these lenders prefer that the nature and objection of your business aligns with the lenders goals before they will lend to you.
d. Micro and Alternate Lenders lend to riskier borrowers have low credit scores, and lend low amounts of money with high interest rates.
6. Submit the Loan Package. The loan package that you submit to the lender when applying for a loan should include:
Business Financial Projections
Personal Financial Information
Personal Tax Statements
Information about business, location, sales contracts, etc.
Business Owners’ Resumes
7. Wait. After you apply for the loan the lender can take up to two weeks to make its decision. If you have been approved for the loan, it can take another two weeks for the money to be disbursed. Typically, the larger the amount of money the longer it takes for the process to be completed.
Small Business Administration (SBA)
The U.S. Small Business Administration (SBA) was created in 1953 as an independent agency of the federal government to aid, sponsor, and assist a variety of products and services to benefit small businesses. The SBA helps small business owners start by offering loans made available through the guaranteed loan programs. The SBA partially guarantees loans made to small businesses by approved and participating lenders, such as banks and finance companies. Guarantees from the SBA help lenders make loans to borrowers that would not have access to conventional financing under similar terms and conditions. So the SBA does not directly fund the loans to the borrowers. Borrowers are actually applying for a commercial loan that is structured based on SBA requirements with an SBA guaranty. The SBA guarantees that these loans will be repaid, so this eliminates some of the risk to the lending partners. Below are the guaranteed loan programs available through the SBA:
1. 7(a) Loan Program. This is the SBA’s most popular loan program. It is designed for start-up and existing small businesses, and is delivered through commercial lending institutions. The 7(a) loan product is most commonly used by franchisees to start a leased location, purchase existing franchise units, purchase smaller real estate properties, business expansions, and partnership buy-outs. 7(a) loans have a maximum loan amount of $2 million. SBA can guarantee as much as 85% on loans of up to $150,000 and 75% on loans more than $150,000. SBA’s maximum exposure is $1.5 million. This means that if a business receives an SBA-guaranteed loan for $2 million, the maximum guaranty to the lender will be $1.5 million or 75%. Both fixed and variable rates are available for 7(a) loans. Interest rates can be found at the SBA website or through your local lender. Loan maturities are based on the ability to repay, the purpose of the loan proceeds, and the useful life of the assets financed. However, maximum loan maturities have been established: 25 years for real estate and equipment, and terms for a working capital or inventory loan should be appropriate to the borrower’s ability to repay up to 10 years.
The major types of 7(a) loans are:
- Express Programs
- Export Loan Programs
- Rural Lender Advantage Program
- Special Purpose Loans Program
2. CDC/504 Loan Program. The 504 loan program is also one of SBA’s most popular loan programs. This loan program provides long-term financing for major fixed assets, such as purchasing land or buildings. The 504 loans may be used for purchasing land and improvements, construction of new facilities or modernizing, renovation, or converting existing facilities, or for the purchase of long-term machinery or equipment. The 504 loan program is composed of two separate loans. The first loan is comprised of a conventional loan made by the bank or finance company. The loan will typically be up to 50% of the project cost and be secured by a first lien on the subject financed assets. The second loan is a debenture made by a local Community Development Corporation (CDC). This loan is typically up to 40% of the project cost and secured by a second lien on the subject financed assets. The remaining project is financed with the borrower equity. The SBA guarantees a maximum of $2 million for the CDC’s outstanding loan.
3. Microloan Program. This program provides very small short-term loans to start-up, newly established, or growing small businesses. These loans are mainly used for working capital or the purchase of inventory, supplies, furniture, machinery, or equipment. SBA makes funds available to nonprofit community based lenders which, in turn, make loans to eligible borrowers in amounts up to a maximum of $35,000.
4. Disaster Assistance Loan Program. This program provides low interest loans to homeowners, renters, and business owners to replace the property and assets that may have been damaged or destroyed due to a disaster. This loan can be used to replace damaged real estate, personal property, machinery and equipment, inventory or business assets.
Who can apply for an SBA loan?
In order to become eligible for an SBA loan, you must have applied and been turned down for a conventional loan by a commercial lender. Most small businesses that meet this requirement are eligible for SBA loans. However, there are some businesses that are ineligible. If a business can obtain funds on reasonable terms from a bank or other private source then by law, the SBA does not have to guarantee a loan to this business. Eligibility generally depends on four factors: 1) the type of business, 2) the size of the business, 3) the use of loan funds, and 4) special circumstances. (8)
- Type of Business
o The business must be a for-profit enterprise.
o It must engage in or must propose to do business in the United States or its possessions.
o The business owner or loan applicant must have a reasonable financial investment in the business.
o The owner must invest other financial resources, including personal assets, before applying for an SBA loan.
- Size of Business
o Most businesses qualify as “small” under the SBA size guidelines located on their website.
o Your business is within SBA size limits if it is in manufacturing or wholesaling with fewer than 100 employees or in retailing or service with annual sales under $5,000.000
- Use of Loan Funds
o Business owners may use SBA loans for a number of business activities including:
§ purchase of real estate
§ construction, renovation, or leasehold improvements
§ acquisition of furniture, fixtures, machinery, and equipment
§ purchase of inventory
§ working capital
A business owner cannot use an SBA loan: (8)
- To purchase real estate where the participant has issued a forward commitment to the developer or where the real estate will be held primarily for investment purposes.
- To finance floor plan needs.
- To make payments to owners or to pay delinquent withholding taxes.
- To pay existing debt, unless it can be shown that the refinancing will benefit the small business and that the need to refinance is not indicative of poor management.
- Special Circumstances
Certain other requirements and restrictions apply to businesses and applicants in the following categories:
- Recreational facilities and clubs
- Farms and agriculture
- Fishing vessels
- Medical facilities
- Alter egos
- Change of ownership
- Probation or parole
- Academic schools
- Special Circumstances
Certain types of businesses are explicitly ineligible for SBA loans. Ineligible businesses are those characterized by any of the following:
- Real estate investment and other speculative activities
- Lending activities
- Pyramid sales plans
- Illegal activities
- Gambling activities
- Charitable, religious, or certain other nonprofit institutions
- Businesses with an owner who is on parole
How to apply for SBA loan
If you want to apply for a SBA loan, you will need to obtain an application from your local lender or at your local SBA office. The SBA has at least one district office in every state and also has local SBA resources in every state. These locations can be found at the SBA website (www.sba.gov). However, there are several variations of SBA’s loan programs so it is best to set up a meeting with a local lender who will be able to provide information about both the bank and SBA documentation required. When meeting with your lender, the SBA recommends that you plan to bring the following information and documentation (2):
- Business Plan. A written document describing your business, including type of business and legal form; annual sales; number of employees; length of time in business; and the ownership structure.
- Financial Statements (Business). Complete financial statements for the past three years and current or interim financial statements.
- Financial Statements (Personal). Each owner, partner, officer, and stockholder owning 20 percent or more of the business must also provide a financial statement.
- Loan Request. A description of how the loan proceeds will be used, along with the purpose, amount of loan request, and type of loan requested.
- Collateral. A description of the collateral that will be used to secure the loan; description of equity in the business; potential to borrow funds; and availability of any cash.
- Management Resumes. The resumes of those who will be involved in operating the business.
After presenting your documentation or application to your lender, you make then submit the SBA loan application to the SBA. According to the SBA, a credit decision on a complete loan package is usually made within ten working days after it is received by the SBA, not including bank processing time. This time line is only accurate if the borrower and lender have provided all the information necessary to process the loan.
The Economy and Loans
As an economy fluctuates, the supply and demand for loans change. Small businesses tend to be moderately effected by shifts in economy, especially more so than large businesses. There is not a lot of information on small businesses so lenders often have a hard time evaluating how creditworthy small businesses are. This makes it especially tough for a small business to get a loan during a recession. An economic recession can mean several things for a small business. As lenders are generally more risk averse in an economic slow-down, they decline more small business loans. Also, a recession will deter small business to take on projects (which need money) because of the uncertainty in profits, which then reducing small business loans. Lastly an economic recession reduces the risk adjusted opportunities for small businesses to invest which will also reduce the amount of loans. The supply and demand graph above shows the effect of the economy on loans. The supply curve represents the amount of capital (horizontal axis) available at the interest rates (vertical axis). (2)
When applying for a loan, be it for your small business or even for personal use, there are many common mistakes that are easily avoidable. One of the biggest mistakes is not knowing your credit score before applying for a loan. To obtain your credit score, you need to obtain physical copies of your credit score from the three major credit bureaus. These bureaus are Equifax, Experian, and TransUnion. This information will allow you to know beforehand if your loan is likely to get approved. Another major mistake that can hurt you in the long run is not locking in an interest rate. By not locking in an interest rate, you are leaving yourself vulnerable to a rising interest rate in the future. Along these same lines, it is vital to fully understand all the terms of the loan before signing it and realizing down the road you made a mistake or failed to notice certain terms in your loan agreement. Another important factor in being approved for a loan that many applicants overlook is having a business plan in line. In order to be approved for a business loan, lenders need to see how and where the money they give you will be spent, and if you are just starting a new business, to examine your business goals. Along with a business plan, another integral piece of being approved for a business loan is having your finances in order. This is one of the biggest mistakes that borrowers make when applying for a loan. Whether you are applying for a business or a personal loan, it is necessary to not only have your financial statements in order, but make sure they are correct and up to date as well. Another seemingly obvious, yet commonly overlooked aspect of being approved for a loan is not making any major changes to your business in the time close to you applying for the loan. Lenders prefer to see stability in a business, and making swift changes does the opposite of that. The final two mistakes that borrowers generally make when applying for a loan go somewhat hand in hand. First, it is key for the borrower to have at least some equity in your project or business. If you do not have a substantial stake in the business, be prepared for lenders to be apprehensive as to why they should take on risk if you are not even doing so. On top of this, it is also necessary to have collateral. Collateral is defined as “of, relating to, or guaranteed by a security pledged against the performance of an obligation.” In Lehman’s terms, this simply means having assets on hand to back up your loan in the event that you default. Defaulting on a loan occurs when the debtor or borrower fails to fulfill their side of the contractual agreement, or not making payments towards the debt. Although many of these common mistakes seem too simple to avoid when applying for a loan, all too often a potential borrower is turned away because of one of these mistakes.