Building Credit With Loans

If you are a good borrower, meaning you repay what you borrow in full and on time, borrowing can be a good way to improve your business credit rating. After successfully repaying several loans, future lenders will look more favorably on your requests for additional financing.

When evaluating a company's credit history, what type of loans have been borrowed and repaid doesn't really matter to a potential lender. Repaying a credit card balance or a bank loan are both excellent ways to establish, improve and build business credit.

When you are considering ways of building business credit, factoring can be especially helpful. If you acquire funds from your unpaid customer accounts through a factoring transaction, you can use these funds to pay off any other accounts you may owe. Additionally, factoring is one of the only kinds of financing that is not reported to the credit bureaus, so when you apply for a commercial loan, any outstanding factoring accounts will not negatively impact your business credit history.

Loan Terms

Once you have qualified for a commercial loan, the next step is to negotiate the terms of the loan and the repayment schedule. In many situations, these terms are set by the lender and are non-negotiable. However, in certain situations, it is possible to establish terms of the loan that are beneficial to the business, especially when dealing with private financing through family and friends.

Repayment Terms

The first issue to decide on when setting up terms for a loan is how long the borrower has to repay the loan. Financial institutions consider a short-term loan to be one that will be repaid in one or two years. Long-term loans have repayment terms that are longer than one or two years.

Small business loans typically fall under the short-term category, with the financial institution requiring repayment in less than two years. Some exceptions are made, including commercial real estate loans so that a company can purchase an office, a strip mall, or a factory that is needed to run the business.

Interest Rates

The interest that is charged on a loan is how a lender makes its money, and the interest charged on small business loans can vary widely. The top two factors that determine interest rates are the condition of the market and the credit rating of the borrower or business. The reference point for all interest charged is called the overnight lending rate. This is the rate that financial institutions pay, and it is set by the Federal Reserve. When this rate is increased, it is an indication that all other interest rates will rise as well. The overnight lending rate in March 2007 was 5.25%.

While the overnight lending rate influences all other rates, this is not the interest rate that will appear in the terms of the loan you apply for. Since the following interest rate terminology is what you are more likely to see on your loan documents, it is important to become familiar with them:

• Prime Rate - This is the benchmark that is used to fix the interest rates charged to borrowers. Only the largest corporations with the best possible credit rating can usually qualify for a loan with an interest rate set at the prime rate, which was 8.25% in March 2007. In the past, this rate has been as low as 4% in May 2004 and as high as 20.5% in August 1981. Often, interest rates will be reflected as a certain number of percentage points above the prime rate, for example “prime plus three” would be the prime rate plus three interest percentage points.
• Applicable Federal Rate (AFR) - This rate involves a short-term, mid-term, and long-term interest rate that is established monthly by the Internal Revenue Service and adjusted on the first day of each new month. In April 2007 the AFR for short-term loans compounded annually was 4.9%; it was 4.61% for mid-term loans; and it was 4.81% for long-term loans. An index of AFRs is available online at www.irs.gov/taxpros/lists/0..id=98042,00.html. In the commercial lending industry, the AFR is often used to set the interest rate on a business loan and is an appropriate guideline to use to set the rate on an interfamily loan.
• Usurious Rate - Financial institutions can charge whatever interest rates they want to, as long as they do not break any state usury laws that are in place. Some states have more modest interest rates governed by their usury laws, while others do not have any usury restrictions whatsoever.
• Fixed Interest Rate - With a fixed interest rate, the same amount of interest is charged throughout the term of the loan.
• Variable Interest Rate - With a variable interest rate, the interest charged throughout the term of the loan can change. Sometimes these changes are a reflection of market conditions, and other times interest rates are adjusted based on pre-determined increments spelled out in the terms of the loan. For instance, if the variable interest rate is tied to the prime rate, and the prime rate increases, the interest charged on your loan will go up accordingly. With preset increases, your interest rate is usually fixed during the first six months of the loan, but after that it will increase regardless of market conditions or other factors.

Secured vs. Unsecured Loans

An unsecured loan means that the lender does not require any type of collateral to guarantee the loan. Typically, you must have a very positive credit history in order to qualify for such a loan. On the other hand, a secured loan is guaranteed by some type of collateral, usually equal in value to the loan amount. The following section explains collateral in greater detail.

Collateral

When a lender requires collateral as part of the terms of a loan, this means that you agree to forfeit certain designated personal property to compensate the lender for any losses it might experience if you fail to repay your loan. Having collateral when you apply for a loan creates a much less risky situation for the lender and may help you qualify for a loan that you otherwise might not qualify for because of any other weaknesses in your credit history.

Sometimes a lender may require possession of the designated collateral during the life of the loan as insurance against default. However, typically a lender will wait until you have failed to meet the terms of the loan before they will seize the property that has been designated as collateral. When you use collateral to guarantee a loan, such as machinery or other equipment, there are restrictions on what you can do with the property while it is encumbered as collateral. According to the terms of the loan, you cannot sell the property or dispose of it in any way, because this would prevent the lender from any recourse it may have should you eventually default on your loan.

The following chart shows the types of collateral lenders will typically accept as a loan guarantee and the percentage of the value of the property that will count as collateral:

Repaying a Loan

Typically, loans are either repaid through monthly installment payments or in a balloon payment where a large sum is due at the end of the loan. When monthly installment payments are required, it is sometimes possible to have the payments automatically deducted from your checking account. This is not only an opportunity to save you time and energy in making the payment, but many financial institutions offer slightly lower interest rates for making automated payments.

Trade Accounts

When your business involves merchandise sales or other types of delayed payments of 30-60 days or more, you often have to wait to actually collect the money owed to you by your customers based on the terms that you have agreed to. During this time, you are acting as a short-term lender because you've allowed your customers to get what they needed without any interim payments or interest.

How Factoring Can Help

Rather than waiting patiently for your customers to pay you what they owe you, you can use a collection method known as factoring to turn your accounts receivables into cash. The first step is to locate a factor that specializes in your industry, such as shipping or apparel. Then you make an agreement with the factor of what percentage of your outstanding invoices they will keep once they collect on them for you. This amount can vary depending on your business volume, the average amount of each outstanding invoice, the credit history of your customers, the terms of the invoices to be collected, and conditions within the industry. Typically, you should receive 80-90% of the total outstanding invoices, and a factor will turn over the funds from collected accounts within one to two days of collection.

A factor usually charges between 2% and 4% of the collected funds as a factoring fee (or origination fee). They may also charge an interest fee on the funds advanced to you or an additional factoring fee, which could turn out to be even more than the interest rate. When borrowing through a factor, your business credit rating is not taken into consideration, only the credit rating of your customers matters, which may or may not help you when it comes to financing fees you will have to pay.

Additional Trade Account Financing Options

Another way to convert trade accounts into immediate cash is to find a company that lends money against outstanding credit card payments. Companies such as Advance Me, Inc. (www.advanceme.com) will lend money to almost any business that accepts credit cards on a regular basis. There is no application fee, and the loan application itself is very simple. In order to qualify, a company must have a minimum of $1,700 of monthly credit card sales and have been in business for at least one year. Once approved, the funds are available within 10-14 business days. No payments are made against this loan; the company who loans you the money is repaid through future credit card collections. For their efforts, companies such as these typically receive 30% or more interest on the funds loaned.

Private or Public Offerings

By enabling the public to buy bonds, large corporations listed on exchanges can effectively borrow money from the public. The people who buy the bonds are loaning the funds to the corporation that issued them, and just like any borrower, the corporation repays the principal amount loaned through the bond plus additional interest fees. Unfortunately, privately owned businesses are not able to sell bonds.