Small Business Loan Agreements – Why the Fine Print is Important
As a small business expands operations, it usually turns to external sources of finance. Most commercial banks have dedicated loan programs for small and medium-sized businesses. In the recent past, a number of alternative lenders have also started providing funds to small firms.
Regardless of the type of lender it is borrowing from, a small business should first understand exactly what it is agreeing to when it signs the loan documentation that is provided to it. When taking a loan, it is a common practice to accept all the standard terms and conditions that are stipulated by the financial institution.
But are these terms and conditions acceptable to you? Is it possible that some of them could put a great financial stress on your business? Before accepting them blindly, the least that you should do is to read them carefully and determine the impact that they could have on your company.
Is the rate of interest fixed or floating?
How does a small business decide which lender to select? While there are several factors to take into consideration, the interest rate that is being charged is of primary importance.
A low interest rate serves several purposes. It reduces the strain on your cash flow and improves your profitability. Over a period of time, this strengthens your financial position and gives you the ability to compete in the market.
A high rate of interest, on the other hand, has the opposite effect.
When evaluating a lender’s proposal, every entrepreneur gives the rate of interest great importance. However, many business owners do not pay adequate attention to whether the rate can be varied by the lender during the tenure of the loan.
If a clause in the loan agreement allows the lender to vary the rate when the rate which it is linked to changes, it could have a direct impact on the cash flow of the borrowing company.
Your borrowing rate could be linked to SIBOR (Singapore Interbank Offered Rate – the rate at which banks borrow from other banks) or to SOR (Swap Offer Rate – a variation of SIBOR but denominated in US dollars). If you don’t notice that your rate is a floating rate you could be in for an unpleasant surprise when the bank informs you that your monthly instalment has been increased.
For example, Maybank offers commercial and industrial property financing at rates that are fixed or which could be linked to SIBOR. Similarly, Standard Chartered Bank offers business equipment loans that have a floating rate of interest.
A penalty for paying early
A prudent business owner would always try and minimise interest costs. At times you may receive an unexpected inflow of funds which you don’t need in the near future. The logical step to take would be to pay down an existing loan.
However, your loan agreement may not permit you to do this. Even if you are allowed to pay early, the lender may stipulate that you will have to bear a penalty for this facility. This penalty is usually calculated as a percentage of the amount that you are paying down and may be in the region of 1% to 3%.
Why should the bank penalise you for prepaying? The reason is that when they make a loan, they have to arrange funds for this purpose. They incur certain costs in doing this. They would also be earning a profit on the money that they lend you. If you pay early, you are denying the bank its anticipated profit. Hence, the prepayment penalty.
If you have taken an SME working capital loan under the SPRING program, you are not allowed to prepay at all. However, you can opt for full redemption by giving a month’s prior notice to the lender.
Additional interest for delays and other charges
Missing the due date of your monthly instalment can prove to be costly. The fine print of your agreement will invariably contain a clause that stipulates the charges that you will have to incur for paying late.
While it is quite reasonable for the bank to impose additional interest for a late payment, it is advisable for you to study the loan agreement to confirm how much you will have to pay. Usually, the extra interest is calculated at a rate that is far in excess of the original rate. If you are borrowing at 9% per year, the bank could charge as much as 3.5% additional interest taking the total cost to 12.5%. The additional interest could even be well above 3.5%.
Business owners would do well to confirm the rate of interest for delays before they finalise the loan agreement. It is important to take this step because this additional interest cost will be levied at the time when you can least afford it.
The reason that you would have missed the due date on your instalment would probably be a shortage of cash. When the bank imposes a penal interest rate, your business would experience a further squeeze on its liquidity.
The terms and conditions of the loan agreement could impose other costs as well.
- An initial fee for the loan facility. This could be in the region of 1% to 2% of the loan amount.
- An annual fee.
- A fee for every delay in the payment of the monthly instalment. This is in addition to the additional interest on delays.
- An extra charge for a change that you request in the terms of your loan.
It pays to negotiate
It is quite possible for a bank or other lender to alter the terms that it initially offers. How can you get the financial institution that you have approached to amend their standard agreement in your favour?
The first rule to follow is to negotiate with at least two lenders. By doing this, you can carry out a comparison and opt for the bank which offers more favourable terms. You should also study each of the clauses of the agreement carefully (or get your accountant to do this) and negotiate for better rates/lower costs/ reduced penalties.
Remember that the bank is as keen to lend to you as you are to borrow. You can use this to your advantage and get them to modify the loan agreement so that it offers your business better terms.