The Right Loan For the Job

When I was a kid, I loved to tinker around in the garage and make little wooden crafts. Now, let’s be clear – I was terrible at it and would get easily frustrated. I once made a small shelf that had three drawers. Only one of the drawers worked because the shelf was not square. As a result, the only way to open the other drawers was to hook a chain to a Mac truck and pull it open. Part of the reason I would get frustrated is that I would not always have the right tools to achieve the goal. As a result, I would use the tools I had incorrectly, and the result would be disappointing.

 The same applies to entrepreneurs when it comes to using loans. There are many different loan types and if used improperly, the result could be disappointing. Below are three questions to ask yourself so that you can choose the right loan type, for what you are going to use it for.

 How is this loan going to help sustain or generate higher profits?

Most loans have fees and interest costs. Every dime of fees and interest that is paid comes directly out of your pocket. You need to know exactly how this loan is going to help your business sustain and grow profits. If what you are going to use the loan for, does not do either, then you need to evaluate if a loan is needed.

One example is the entrepreneur who has 10 rental properties. He wanted a loan to repair the AC units in 4 of his properties but didn’t have the $20,000 needed to pay cash. I was able to provide him with a short-term loan. We also talked about the need to set up a repairs and maintenance escrow account. The concept of escrowing for his property taxes and insurance expense was understood, but no one took the time to educated him about apply the same principal to his annual repair and maintenance expense. His lack of planning cost his profit account $4,000 due to the loan costs.

Assuming the loan is going to help you sustain or grow your profits, you also need to consider your return on your investment. Let’s believe that the purchase of the new AC units did not increase profits, but rather sustained them. Additionally, if the sustainable profit was $2,000 a month, then the investment of $24,000 (cost of the units plus the loan costs) to replace the units was worth it. The entrepreneur would be able to get a very quick return on his investment. However, assume that the sustainable profit was only $100 a month. Then, investing in the units would not make sense. The entrepreneur would be better off finding a cheaper alternative.

How does this loan impact my financial flexibility?

Financial flexibility is the degree to which an entrepreneur can use their finances to adapt to a changing environment. This is something that every entrepreneur should obsess over and find ways to maximize. You can make very different decisions when you don’t have to pay the bank a monthly payment. Financial flexibility associated loans is maximized when you get as low a monthly payment as possible and then make extra payments to pay off early. When looking at getting a new loan, you should always ask yourself – is the new loan terms and structure going to increase, decrease or not impact my financial flexibility.

Does my repayment plan match the useful life of this asset?

You wouldn’t take out a 30-year loan to buy a vehicle, would you? Of course not, if you did, then you would still be paying for the car 10 years after it was recycled into manhole covers. You need to match the loan repayment with the useful life of the asset you are purchasing. Here are the most common types of loans and the types of assets they match up with.

• Credit cards are unsecured working capital lines of credit. They are great for convenience and tracking expenses but should be paid off every month. You should never purchase and finance an asset on a credit card. Most credit cards do not charge interest if you pay the card in full each month but very high interest if you carry a balance past 30-days. A good rule of thumb is, if you can’t pay the balance off every month, then do not use them.
• Traditional lines of credit (either secured or unsecured) are intended to fill a short-term working capital need. The asset you are financing is your inventory or accounts receivable. This need may be longer than one month, but when you receive payment from your client, then you need to pay the line back. Teaser alert, next week’s post is going to explore lines of credit in more depth.
• Term notes allow you to get an asset now and pay for it over a longer period. You want to get the longest amortization possible, but not one that is longer than the useful life of the asset. (Think back to the 30-year car loan.) If you are in an industry that requires continued equipment replacement (for example, a lawn care company that must buy new equipment each year), then I would challenge you to change your mindset when it comes to replacement financing. You can set money aside in an equipment purchase account so that you can pay for these replacements every year with cash and eliminate the need to borrow. An alternative to this would be to lease the equipment, which would make the asset replacement cost an operational cost.
• A hybrid between a line of credit and a term note is a guidance line. This is a pre-approved commitment that an entrepreneur can draw on (like a line of credit) to create a new term loan when purchasing equipment. The terms of the new loan are pre-agreed, so the entrepreneur knows exactly what type of structure to expect. Imagine an over the road trucking company that has a fleet of 75 trucks. Every year, the company replaces 4 trucks (costing about $100,000 each), and they do not want to use their operational reserve to pay cash for the trucks. The bank can set up a $400,000 guidance line that will finance 100% of the truck purchase. The entrepreneur simply provides a bill of sale and within 24-hours the banker will deliver documents to finance the truck on a 7-year loan at a 5% interest rate. The entrepreneur has financial flexibility in knowing the terms and can then decide exactly how much to finance. Since the line is already approved, the closing process is fast and painless.

One amazing thing to consider is using multiple loan structures to help you accomplish your goals. Imagine that you have decided to replace the carpet and the furniture in your office. Unfortunately, you don’t have a carpet and furniture replacement fund set up and funded. The cost of the project is $20,000. Now image that you have a $25,000 credit card, a $100,000 line of credit and a good relationship with your banker. My recommendation would be a 3-step process:

Step 1: Pay for the project on your credit card

Step 2: Before you are charged interest on the credit card, pay it off using your line of credit. This is assuming that you will not need to use your line of credit in the next 30 days, if you do skip step 2 and go directly to step 3.

Step 3: Contact your banker and ask them for a 5-year loan to pay the line of credit off. The payments may be low for the 5-year loan, but I would recommend paying more so the loan is paid off in 3 years. Make sure there is no penalty for early payment.

Being an entrepreneur is one of the most difficult and demanding things you can do. The good news is that entrepreneurship today is a team sport. Let’s connect on LinkedIn and together we will start taking control of your business finances which will lead to peace, fulfillment and achievement of your strategic goals. When we connect, tell me about how you have historically chosen a loan type.

Greg Martin is an entrepreneur’s insider to the banking industry and passionately believes that every person was uniquely designed for a higher purpose and calling. Greg guides entrepreneurs in defining and achieving their purpose and calling. His deepest passion is living life with his wife of 17 years and their wonderful son.