Types of loans offered by Commercial Banks for business
As you get established in your business, you will increasingly turn to financial institutions to provide financing for your businesses. This article briefly explains the types of loans offered by Commercial Banks.
Almost every small business has a relationship with a commercial bank through a depository relationship. One of the first actions a new small business takes is to set up a checking account, which is usually opened at a commercial bank but sometimes at a thrift: Consequently, when you need funds for your businesses, it is natural for you to approach your commercial bank.
KEY POINT: Commercial-bank small-business loans are a major source of funding for small companies. Typically, however, these loans are only available to the well-established small company with a track record of good credit performance with other forms of loans.
Commercial-bank loans come in a variety of forms including short-term loans, lines of credit, floor plan, construction loan lines of credit, long-term loans, equipment loans, real-estate loans, and letters of credit. A business qualifying for bank credit may have more than one of these forms of bank loans, each being tailored in its terms and conditions to serve a specific purpose. The nature of each of these loans are briefly described below.
Short-term loans are commercial loans of one year or less. They are used to finance the short-term seasonal working-capital needs of a business, such as a build up of inventory by a retailer before the Christmas season.
Most short-term loans are structured with thirty, sixty, or ninety-day terms, with all principal and interest being due at maturity. They are paid off when the assets purchased with the loans have been sold and the business has recovered the cash invested in them.
The lender may take a security interest in the current assets the short-term loan is financing. In many industries, the banks take security for the short-term loans only against the accounts receivable, leaving the inventory to reassure the trade credit.
Lines of Credit
Lines of credit are longer term arrangements. They allow a business periodically to borrow short-term over a longer period than a year without formally getting a new loan each time it needs funds. In a line of credit, a bank agrees to the maximum amount it will let a customer borrow. The customer may then borrow and repay at will, up to that limit.
The outstanding balance is due when the line-of-credit agreement expires, although these agreements frequently provide that the loan must be repaid completely for part of every year.
Line of Credit
A bank line of credit is designed to help a business maintain a regular cash flow in its day-to-day operations even if the business has significant volatility. The lender will often take assignment of current assets as security. The amount that can be drawn on the line may be set as a proportion of those assets but with a fixed dollar maximum.
The terms might provide, for instance, that the company can draw up to 85 percent of its accounts receivable but no more than $1 million. Many factors are used by the bank in setting the limit on the line including the client’s financial strength, need for credit, and the quality of the collateral.
Floor plans are specialized lines of credit financing the purchase of specific items. They are typically available to businesses whose inventory is characterized by large, easily identified, expensive units, such as automobile dealerships. The floor plan allows the retailer to buy inventory from the manufacturer and repay the line when the unit is sold.
The bank typically has a security interest in each specific unit, which is released when the dealer sells that unit to a retail customer and repays the loan. Retail stores selling large-ticket consumer items, including automobiles, home appliances, furniture, and boats, can use floor plans to finance their inventories. Sometimes, the manufacturer will provide the floor-plan financing.
Construction loans are short-term loans to finance the construction of new real estate, both residential and commercial. They are usually repaid either by the sale of the real estate when the construction is complete or when the borrower gets a long-term mortgage on the property. Real-estate developers and building contractors are the principal users of construction loans. These loans are almost always secured by a mortgage on the property the loans are used to construct.
Long-term loans are normally defined as loans that are repaid according to a defined schedule over a period greater than one year. Most long-term bank loans have a maximum maturity of five years. The term of a specific loan is usually shorter than the useful life of the asset purchased with the loan. For example, loans to buy delivery vehicles for a business would have maturities tied to the period the vehicles were expected to be in use.
Equipment loans are a specific type of long-term loan used to purchase equipment used in the business. Equipment loans finance a variety of equipment from computers to metal stamping equipment to construction equipment. Typically, an equipment loan’s maturity is tied to the expected useful life of the equipment financed. Useful life is determined by when the equipment becomes obsolete or wears out, whichever comes first. These loans are normally secured by a lien on the equipment financed.
Real estate loans
Real-estate loans are loans secured by a mortgage on an existing piece of residential or commercial real estate. A real-estate loan may be used to purchase real estate, although lenders typically will finance less than 100 percent of the price. Alternatively, the real estate may be used to secure a loan used for another business purpose such as buying inventory.
Letters of Credit
Letters of credit are liabilities of the banks that issue them. They allow the beneficiary, or recipient, of the letter of credit to present the letter to the issuing bank under defined circumstances and be paid an amount stipulated in the letter. Letters of credit are used in a variety of ways to finance trade and are most actively used in international trade.
Because of the bank’s unconditional agreement to pay if the beneficiary presents the required documents (thus the term “documentary” letter of credit), banks issue letters of credit only for their most creditworthy customers. As an alternative, the bank will want strong collateral such as cash in a blocked account.