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AmextaFinance > Small Business > Three Strategies To Choose The Right Loan Terms For Small Businesses
Small Business

Three Strategies To Choose The Right Loan Terms For Small Businesses

News Room
Last updated: 2023/05/11 at 8:48 AM
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Cofounder / Partner at Lendzi.

Contents
1. Match your term to your liability.2. Choose the most cash-flow effective term.3. Make sure you have a way out.

The past two years have been something of a gut check for small businesses in so many ways. From shutdowns caused by the pandemic, to the “Great Resignation,” to “quiet quitting,” businesses have had to be nimble to navigate both macroeconomic factors and staffing issues.

But perhaps the greatest upheaval has come in the form of skyrocketing interest rates. As inflation raced towards four-decade highs coming out of the pandemic, the Federal Reserve has raised the fed funds rate from essentially zero toward the 5% range—with indications the hikes could slow down soon.

What this means for small businesses is that the cost of financing has similarly exploded to the upside, all in the midst of an inflationary environment that some say may trigger a recession—and may already have.

To navigate all of these challenges, it is important that small businesses choose the right loan terms for their financing needs. When rates were lower, terms typically weren’t as important to businesses, as the interest paid was negligible and there always seemed to be a low-cost or even 0% option available. But with rates trending up, a misstep in planning your debt portfolio could prove costly.

To help you steer your small business to safe waters, here’s a look at some debt financing strategies that you can choose from to find the optimal financing match for your company.

1. Match your term to your liability.

The traditional way to take out a business loan is to match the maturity date of the loan with the duration of your liability. For example, if you buy a machine with a useful life of 10 years, it often makes sense to have your loan mature in a decade. During the entire period of the equipment’s useful life, it will theoretically be generating cash flow that you can use to make your loan payments. If your machine lasts beyond its expected life, the remaining cash flow turns into an additional stream of profits for your company.

2. Choose the most cash-flow effective term.

In some cases, current market conditions may be the best guide of how you choose the term of your loan. For example, as of early 2023, the yield curve is highly inverted, meaning short-term interest rates are higher than long-term ones.

This is not the traditional position of the yield curve. In this scenario, even though you may not need or want a longer-term loan, it may suit your company’s cash flow better to go farther out on the curve, taking out say a 15-year loan instead of a five-year one. This can reduce your monthly payments in two ways: First, a longer-term loan stretches out your payments over additional pay periods, meaning each monthly payment is lowered. Second, if you can snag a 5% loan instead of an 8% loan, for example, you’ll also be saving on your monthly interest.

The caveat with financing like this is that if you’re forced to keep the loan for a significantly longer period of time, you will end up paying more in interest over the life of the loan, even if the nominal rate on the loan is lower.

3. Make sure you have a way out.

Regardless of the type of financing you choose, I suggest you always have a “way out” if it turns into a bad deal. For example, if you are forced to take out a high-interest loan during a period of elevated market rates, avoid choosing loans that prevent you from refinancing with no penalty. That way, you can take out your loan when you need the cash, but if rates fall, you can boost your cash flow by refinancing into a lower-rate loan.

Similarly, I recommend to pick loans that carry no penalties for early payoff. If your company improves its financial position and no longer needs a loan, you may want to be in a position where you can pay it off early and remove the drag from your cash flow.

Choosing the right financing for your business isn’t always as simple as it may seem. Speaking with an unbiased expert in business financing could be a good first step if you’re looking to get the maximum value out of your loan. Although you generally want to find the lowest-rate loan, there are numerous factors—including the type of business you run, how you intend to use the loan proceeds and the current macroeconomic environment—that can also play an important role in the type and terms of loan you should seek.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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News Room May 11, 2023 May 11, 2023
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