There are many different types of bank loans, each having their own respective purpose. All bank loans are categorized into two distinct groupings; secured and unsecured loans. Within in each category of loans there are several different sub-types of bank notes used to make a loan. Both categories require the owner of the small business to provide a personal guarantee to ensure the loan is paid back.
The following categories identify and explain the different types of bank loans used in the small business world.
Banks will lend money to a small business owner on an unsecured basis. Most often this is in the form of a credit card, a personal loan or a short term line of credit. The following describes these three types of unsecured loans.
Bank Credit Card
This is the most common type of borrowing money but you don’t see it too often with the smaller regional or local banks. It is nothing greater than the traditional credit card pushed by the big Citibank or American Express. The larger banks like Bank of America, SunTrust, or BB&T use their own card system and often have their own clearing house to monitor and control the cards.
In this situation, the local bank is the lender. It requires the owner of the small business the ability to exercise the card on a regular basis just like the big chains. For the smaller banks, the balance is cleared each night with a deduction from your account, so really the loan is truly temporary. The card is most often used as a debit card or check card and the bank explains to the user that it is not for long term lending purposes.
A personal loan is a short term loan to satisfy a temporary situation. Banks will use this type of unsecured loan for their best customers. In general they are for less than $50,000 and only require a signature and the money is placed into the individual’s account. Often these types of individuals carry Certificates of Deposit or Savings Accounts that have high balances. It is rare, actually unheard of for a small business owner especially those starting out to get one of these types of loans.
The most common place you will find these is in the farming industry. The banker and the farmer have known each other for years and the farmer has always complied with prior banking instruments (loans). I once had a farming client that told me that he just walked in and said he needed $25,000 and the banker pulled out a fill-in form, both signed and the money was in his account.
Equipment Line of Credit
This type of loan is uncommon because many small business owners don’t request this type of loan. Simply put, the bank allows you to borrow up to a certain amount to have available when you go to negotiate the price for a piece of equipment. The terms require the business owner to convert the this line of credit to a secured format or equipment loan at a future date, say 60 days out. It borders on being a personal loan but the mutual understanding is that it is for equipment. Again, you find this in long term relationships between a bank and a business. Often the bank has other notes with the small business whereby the notes are in good standing and there is equity in those notes to protect the bank’s overall position.
In sheer numbers, this type of loan is the most common for banks. The small business owner negotiates a deal on an auto and the bank loans a prearranged value (typically 60-80%) of the auto’s purchase price. Many small businesses use this type of loan to purchase trucks and vans to outfit the fleet. In general, the bank requires the title of the vehicle and the remaining equity in the fleet as its collateral to protect the note’s downside risk. In addition, the bank will require the business owner’s personal guarantee.
Lines of Credit
This type of loan is extended to the best businesses at the bank. Typically a small business needs cash for short term reasons (less than one year) to maximize operations. A line of credit is set up for a maximum amount and the small business owner is allowed to transfer funds from the line of credit to the business’s bank account at will. Examples of the value of this loan are seasonal operations such as landscaping or retail operations relying on holiday sales. In the landscaper’s business, he may be able to take advantage of volume discounts for plants, trees, seed, and other supplies prior to Spring. Once the customers purchase the supplies he then can pay back the bank.
Another common use of this instrument is for receivables. Some companies have large receivable balances with governmental agencies and these agencies are slow to pay due to bureaucracy. The line acts as a temporary cash pot to meet the day to day needs of the company.
Many lines of credit are secured with the current assets of the company, e.g. receivables or inventory and often are attached to the big assets as well. This includes all fixed assets and the personal assets of the owner along with his personal guarantee. The bank does require that the line be at a zero balance for at least 30 consecutive days per year as a condition of the loan.
Short Term Notes
When a bank writes a check to the small business owner to use as the owner needs, the bank executes a short term note. Most commonly used to meet some unexpected need or for the business to take advantage of a situation, a short term note is the solution. These notes have from 90 days upwards of five years in regular monthly installments to pay them back.
I have seen them used to buy a high end copier, to purchase computer equipment or a network, and I’ve seen one to replace a burnt out motor for a large utility boat. The bank generally requires collateral in the form of the equipment that the owner uses the proceeds to purchase or replace. In addition, the bank requires a personal guarantee of the owner.
Long Term Notes
Similar in nature to the short term notes, these notes have higher face values, typically in excess of $50,000 and require an extended application process to be approved by a committee within the bank. The payback periods range from five years to upwards of twenty years. The most common use of this type of a note is to purchase big ticket items or extend or upgrade the facilities where the business is located. The key is that the note’s lifetime is slightly shorter than the life expectancy of the associated asset. In this type of transaction, the bank requires not only the title or deed to the property purchased, but also requires an umbrella wrap to cover all other assets of the business. Banks rarely lend to new start-ups or young companies unless the owner has significant personal wealth to act as additional collateral. In these start-up or young business situations, the collateral wealth is typically held by the bank. The most common asset the bank will use as collateral is real estate and a deed of trust is filed with the local circuit court. These loans are scrutinized extensively to protect the bank’s position. As in all bank lending situations, a personal guarantee is required.
Mathematically this is the highest percentage of loaned money a bank makes. Just like a mortgage loan, real estate loans require committee approval, lots of collateral and a high net worth for the small business owner to get one of these loans. Banks look for long term relationships with the business as a prerequisite prior to lending for real estate. Most commonly termed over 20 years or more.
Only the best of the best get these types of loans in the post real estate bubble burst. Many banks are still holding real estate loans from several years ago and are very sensitive to a real estate loan. When a small business requests such a loan, the banks are apprehensive in lending more than 75 cents on the dollar for the real estate, especially since most of it is commercial in nature. Again, only the best of the best get these types of loans today. As in all bank loans, the personal guarantee of the owner is required.
There are many different types of bank loans for the small business. All loans are grouped into the two major categories of Secured and Unsecured. Depending on the nature or use of the funds from the loans, the bank drafts the appropriate agreement. In almost every situation, the bank requires a personal guarantee of the small business owner. In future articles I will articulate on how to develop a relationship with the bank and obtain the funding you need to expand operations or purchase fixed assets. As a small business owner, you need to understand the terminology used by the banking industry for these types of loans. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.