How Does a Business Loan Work?
A business loan is an agreement between your business and a lender in which you agree to pay an interest rate on a specific amount of capital borrowed over a specified period of time. As we have discussed earlier, a business loan works very much in a similar fashion to a mortgage. You are lent money and required to pay back the principal and interest. However, there are a number of differences between business loans and other types of loans. As we saw earlier, business loans often come with a substantial number of covenants. These covenants act as a guide of factors that your business must adhere to throughout the life of the loan. Sample covenants include, but are not limited to:
- Maintaining profitability
- Maintaining a positive cash flow that exceeds the interest and principal repayment by a certain factor.
- Maintaining the value of collateral
- A stringent use of how the business loan is to be used.
- Maintaining a strong credit score (both for the business and personally).
Banks and finance companies have a wide range of latitude when determining whether or not to make a business loan, how the loan proceeds can be used, the interest rate, and the repayment period. Of course, like with anything in this world, you are free to reject an offer proposed by a lending bank. The only factor that cannot be taken into account when making a credit decision is someone's race, religion, or other similar characteristics.
In regards to the mechanics of the business loan, a bank or finance company can issue the funds in a number of different ways. First, they could simply write you a check to be deposited into your bank account. However, this is become less frequent as banks want to ensure that the usage of debt funds is in accordance with how you said you would use them. In a different scenario, you could have the bank make purchases of items on your behalf. For instance, if you took out a $50,000 loan to buy a piece of business machinery, then the bank very may well directly pay the vendor for the equipment rather than you paying the vendor. This ensures the bank that the funds have been used appropriately and that the proper collateral is in place.
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