WATCH OUT FOR 100% FINANCING OFFERS
“Too good to be true;” “All that glitters is not gold;” “The grass looks greener on the other side;” three aged sayings but still worth remembering. Be it a hot tip on the fifth race or a penny stock, the odds are neither tip will be your winner.
But horse races and the stock market don’t have an exclusive grasp on illusionary opportunities. More mundane, but much more important for you could be an improperly structured loan. The good news for borrowers is that money supply currently exceeds loan demand, which results in lower rates. However, the bad news is that in their exuberance to make you a loan, some lenders forget that lending should be a long-term relationship, not a short-term band-aid.
When a lender offers you 100% or more financing, regardless of its appeal, it is not in your best interest. In many instances you will be required to pledge additional collateral, such as a lien on your home. Sounds great, no cash down, maybe even some extra cash. But what happens if you want to sell your home before the loan is paid off?
What about the interest rate? Obviously 100% financing is more risky for the lender. Thus, doesn’t common sense tell you that the interest rate will be higher than a more traditional loan advance? There’s more….If you want to finance the purchase of real estate, pledging other business assets could restrict your ability to borrow against them at a later date. Even short-term borrowing needs could be impacted by a mis-match of loan and purpose.
Other aspects you should consider, because your lender will, is cash flow and debt service coverage. Cash flow is the amount of money you have to repay scheduled debt. Specifically, it is net profit plus non-cash charges such as depreciation. If you are buying a building which will replace the one you are leasing, then we would also add back your current lease payments. The objective is to predict your ability to repay the loan.
Generally we look for a debt service ratio of 1.5 times – that is $150 in cash flow to cover a $100 payment (principal and interest). Usually the figures are calculated on an annual basis. Why should you care? The lower that percentage, the less financial cushion you have for future events. What would a 2% decrease in sales or gross profit do to your cash flow? Remember, fixed expenses continue even when sales drop. How does an increase in inventories or receivables affect you? Either of these could limit the cash you have available for repayment of debt.
So when a lender offers you a loan package that includes 100% financing or better, you might want to read the small print. Ask some questions like how long has your lender been in business? Have they always offered such advances? What would be the interest rate if you put 10% or 20% or more down? What collateral do they expect you to pledge? This could be a real insight for you because many non-banks don’t make receivables or inventory loans so they think nothing of taking all of your assets as collateral.
These and many more are the reasons SBA has more than one program. Their two most used programs are 7a and 504. While the 7a can give you longer repayment terms and can include refinancing and working capital, the 504 program has many attractive features.
Specifically, in a 504 loan the borrower puts 10% down, the bank finances 50% of the total project, and SBA guarantees the remaining 40%, accepting second position to the lender. This type of loan can have significant advantages for the borrower (especially the long-term fixed interest rate). A comparison with the 7a should be requested (and willingly provided by any bank you deal with).
The most important point to remember is that SBA is a flexible and viable alternative for small businesses’ financing requirements. The Government guarantees results in a very favorable interest rate, and repayment is longer, which gives you lower payments. If you have questions about the “504” program, call an SBA Preferred Lender.
This Information was provided by California State Bank. For more information, contact 626-915-4424.
