If you’ve applied for a small-business loan, you might have thought that the fine print on your contract sounded like another language. Yet, it’s crucial for you to understand your loan’s terms and conditions.
“[Small-business owners] should know what they’re signing off on,” says Eyal Lifshitz, founder and CEO of BlueVine, an invoice financing company. “The smarter they are, the better decisions they can make.”
The following are seven terms you should know before agreeing to a loan:
1. Origination fee
Financial institutions often charge an origination or application fee to “help defer some expenses that go into evaluating credit requests,” says Jim Salmon, vice president of business services at Navy Federal Credit Union. “Anyone that’s going through the business credit application process will see the information required … can be substantial.”
The cost may be expressed either as a dollar amount (for example, $500) or a percentage of the loan (such as 0.50% of $100,000). You may be able to negotiate the fee with a lender, and you likely won’t have to pay the fee until the deal is approved, according to Salmon.
Origination fees vary among banks and online lenders. Kabbage doesn’t charge the fee. OnDeck short-term loans carry an origination fee of 2.5% on the first loan and 1.25% on the second, with fees waived on subsequent loans. Funding Circle charges a 3% origination fee, while Dealstruck charges 4%.
However, the lender with the lowest origination fee isn’t always giving you the best deal. To get the true cost of a loan, borrowers should ask lenders for the annual percentage rate (APR), which factors in all fees.
2. Fixed rate
A fixed interest rate means just that: The interest rate you pay on a loan doesn’t change during the repayment period. For example, if you have a 30-year, fixed-rate mortgage, you’ll pay the same interest rate and have the same monthly payments for the life of the loan.
When interest rates are historically low — as they are now — it’s often better to take out a fixed-rate loan than one with a variable rate, since you can lock in the low rate over a long period of time. LendingClub, Prosper and Dealstruck all offer fixed-rate small-business loans. SBA 7(a) loans, offered through banks and credit unions, also have a fixed rate.
3. Variable rate
A variable-rate loan is the opposite of a fixed-rate loan. The interest charged on the loan — and your monthly payments — can rise and fall with market fluctuations.
“You have to be comfortable with the fact that your business will … deal with an additional cost if rates go up,” Salmon says.
Business term loans are generally fixed-rate loans, since they’re tied to a specific repayment period. Business credit cards and lines of credit tend to carry a variable rate, since there’s no time frame to repay the entire balance, according to Salmon.
4. Default interest rate
This term refers to the higher interest rate lenders can charge if you fail to make timely payments on your loan. It’s a common feature of credit cards: If you miss payments or go above your available credit limit, you can trigger a higher penalty rate, typically 29.99%.
“In my experience, it’s an interest rate the lender reserves the right to charge, but … usually doesn’t because they want to keep the relationship,” says Craig Coleman, CEO of ForwardLine, a small-business lender and payment processing provider. “But they reserve the right to do it if they really feel like someone isn’t making any effort to pay.”
5. Contract duration
Small-business owners should be aware whether a loan comes with a contract duration, Lifshitz says. This is common with invoice factoring, a financing option in which you sell your accounts receivable at a discount in exchange for cash.
Most lenders that use this technique require you to factor invoices for a specific period of time, typically six to 12 months, according to Lifshitz.
“If you leave them before … the contract ends, they can have a pretty high penalty. It could be 10%,” Lifshitz says.
6. Prepayment penalty
You might expect that repaying your remaining balance early will save you money in interest. But some lenders will slap you with a prepayment penalty for doing so.
You don’t want to get a loan with a prepayment penalty if you want the option to refinance it later on with a lower-cost loan, Coleman says. “Having no prepayment penalty gives you maximum optionality,” he says.
“It all boils down to costs,” Lifshitz says. “When you think about it, you want to get two things: Make sure you’re not paying more than you should, and that you have flexibility.”
Online lenders such as BlueVine, Prosper, Funding Circle, Lending Club, Kabbage and OnDeck don’t charge prepayment penalties.
This fee is prohibited by federal credit unions, as stated in the Federal Credit Union Act.
There may be covenants, or legal provisions, in a loan agreement that require you to fulfill certain conditions, according to Salmon.
“For example, a loan with a bank may require you to maintain all of your business accounts with that bank,” he says. “You have to decide whether that’s right for you or not.”
Another possible covenant might require you to provide financial information whenever the bank asks for it, or require you to maintain a certain level of cash in a bank account, Salmon says.