When you set out to borrow money for your firm, understanding loan types and which product is the best fit for your unique needs, is paramount.
By: Hitesh Khan/
Understanding loan types will require you to know that there are two basic kinds of loans — lines of credit and installment loans — and two general categories of loan length — short-term and long-term.
The purpose for which the funds are to be used is a very important factor in deciding what loan type to request. There is also an important connection between the length of the loan and the source of repayment.
Understanding loan types will require that you know that short-term loans are repaid from the liquidation of the current assets (i.e., receivables, inventory) that are financed, while long-term loans are generally repaid from earnings.
Line of Credit
A line of credit is an arrangement in which the bank disburses funds as they are needed, up to a predetermined limit. In this loan type. the customer may borrow and repay repeatedly up to the limit within the approved time frame.
An installment loan is an agreement to provide a lump sum amount of money at the beginning of the loan. This loan type is paid back in equal amounts over the course of a number of years.
A short-term bank loan can be used for purposes such as financing a seasonal buildup in accounts receivable or inventory. Lenders usually expect these loans to be repaid after their purposes have been served: for example, account receivable loans when the outstanding accounts have been paid by the customers and inventory loans when the inventory has been sold and cash collected.
A long-term loan is usually a formal agreement to provide funds for more than one year, and most are for an improvement that will benefit the company and increase earnings. An example is the purchase of a new building that will increase capacity or of a machine that will make the manufacturing process more efficient and less costly. Long-term loans are usually repaid from profits.
Sometimes your signature and general credit reputation are the only collateral the bank needs to make a loan. This type of loan is called unsecured. At other times, the bank requires a pledge of some or all of your assets as additional assurance that the loan will be repaid. This is called a secured loan. The kind and amount of collateral depends on the bank and on variables in the borrower’s situation.
To understand loan types know that many types of collateral can be pledged for a secured loan. The most common are guarantor, warehouse receipts, chattel mortgage financing, accounts receivable inventory, savings accounts, life insurance policies, and stocks and bonds.
A borrower may ask another person to sign a note in order to augment his or her credit. This guarantor is then
liable for the note: if the borrower fails to pay, the bank expects the endorser to pay. Sometimes the endorser
may also be asked to pledge assets.
A guarantor who assumes an obligation jointly with the maker, or borrower. In this arrangement, the bank can collect directly from either maker or co-maker. A guarantor is an endorser who guarantees the payment of a note if the borrower does not pay. Both private and government backed lenders often require guarantees from officers of corporations in order to assure continuity of effective management.
A bank may take commodities as collateral by lending money on a warehouse receipt. The receipt is usually delivered directly to the bank and shows that the merchandise has either been placed in a public warehouse or has been left on your premises under the control of one of your employees who is bonded. Such loans are generally made on staple or standard merchandise that can be readily marketed. The typical loan is for a percentage of the cost of the merchandise.
Chattel Mortgage Financing
If you buy expensive equipment, such as a cash register or a delivery truck, you may be able to get a loan using the equipment as collateral. The bank assesses the present and future market value of the equipment and makes sure it is adequately insured.
Real estate is another form of collateral, usually for long-term loans. In evaluating a real estate mortgage, the bank considers the market and foreclosure value of the property and its insurance coverage.
In reality there is a hierarchy of money sources if you want to raise capital for your business and if personal sources have been depleted, but understanding loan types and knowing which product best suits your need are useful.
As a high number of applications for SME loans are unsuccessful, besides understanding loan types, it is important for passionate business-owners to work with trusted hands, and people who know the industry. One recent research report said that up to 81 per cent of SMEs in Singapore do not qualify for business financing.
But credit access to SME loans to grow the business is often hindered by the lack the relevant financial knowledge and / or the resources to engage professional business consultancy services to manage and address their obligations and financial liabilities as business owners. The terrain to apply and qualify for SME loan is also uneven because creditors are not just banks but finance companies and other licensed lending entities whose security arrangements may be different or are more complicated.