Debt Finance – Business Loans, Commercial Mortgages & Overdrafts
As mentioned in a recent article on equity finance, we are revisiting the topic of financing options for your business. Over the next two weeks we will be exploring the options available to businesses under the banner of debt finance.
One way or another all businesses need finance and business owners can use debt finance for such things as:
- growing their business
- providing funds for capital expenditure
- consolidating existing borrowings
- or to overcome cash flow issues
There are several options when it comes to debt finance for business. We will consider each and look at the pros and cons. As a finance brokerage, we specialise in arranging debt finance for business owners. So if you have any queries at all, don’t hesitate to get in touch.
We start this week, by taking a look at business loans, commercial mortgages and overdrafts.
Business Loans & Commercial Mortgages
These are loans taken out for an agreed length of time, known as the loan term. The loan term can vary considerably, but typically will be anywhere between 5 and 25 years.
There are two different types of business loan, secured and unsecured. We will discuss unsecured business loans in next week’s blog. For now we will concentrate on secured loans.
The reasons for choosing a business loan or commercial mortgage vary, but primarily are to:
- purchase new or additional business premises
- refinance existing loans within the business for a better deal such as a longer term or a lower interest rate
- or to assist with capital expenditure requirements within the business.
A business loan would normally be for a loan term of up to 10-15 years. The loan is secured against the freehold of the premises from which the business operates.
A commercial mortgage is also secured on the freehold of the premises from which the business operates. However the loan term is much longer and can be for up to 25 years if required by the borrower.
One advantage of these types of loan is that the interest rate and monthly repayments are known from the outset. Therefore the business owner can plan and budget with confidence, and manage their cashflow much more effectively.
That said, a long-term business loan can be less flexible than say for instance a bank overdraft. Additionally, if you pay off the loan early, many lenders will charge early redemption fees.
However, the interest rate on a business loan or commercial mortgage will usually be cheaper than the interest rate on an overdraft.
We offer one significant caution when it comes to business loans and commercial mortgages. The freehold property used as security is at risk if monthly repayments are not met. As such, careful consideration needs to be given to the implications of taking out a secured term loan on a business.
A bank overdraft is arguably the most common way of funding a business. However, because of the many other funding options available these days, it is becoming less common.
That said, a bank overdraft is still very much a part of the borrowing landscape for UK business owners. This is because an overdraft gives you, the business owner, flexibility. You can borrow variable amounts up to a set limit which will have been agreed with your bank beforehand.
Overdrafts are usually unsecured and only require the personal guarantee of the business owner. However, please bear in mind that personal guarantees should not be entered into lightly. In the event of a default, you as the guarantor become personally liable for the debt. In fact, most lenders insist you obtain independent legal advice from a solicitor as part of signing the guarantee.
Loans vs Overdrafts – What’s the Difference?
The main difference between a loan and an overdraft is that a loan is a fixed amount of borrowing over a set term with regular monthly repayments. An overdraft on the overhand, allows you to borrow variable amounts of money as and when you need it, up to a limit that will have been agreed between you and the bank at the outset of the arrangement.
Whilst an overdraft will almost certainly be at a higher rate of interest than a loan, it offers you much more flexibility when it comes to managing cash flow. Furthermore you can draw funds against the agreed limit as and when required to pay for unexpected expenses when they arrive (or when expected income doesn’t arrive!)
However, one of the issues we notice when it comes to business owners taking out an overdraft, is that they are inclined to view the limit of the overdraft as a “target” rather than a “facility”. The result is that they are always operating just below the limit of the overdraft.
This becomes a very ineffective and expensive way to borrow. Many times we have suggested a restructuring of the ‘hard-core debt’ element of the overdraft on to a medium or long-term business loan. This allows the business owner to re-negotiate a lower and more suitable overdraft facility.
In other words, an overdraft should not be viewed as a long-term loan, but rather as a facility to be used to overcome short term “blips” in cash flow. Providing it is used in this way, the overdraft remains one of the most effective and convenient forms of debt finance.
The Final Word
Business loans, commercial mortgages and overdrafts remain common methods for seeking finance for many businesses. However, they are not the only options. So next week, we’ll consider unsecured business loans, invoice finance and asset finance.
Although working remotely for the immediate future, Funding Track continues to provide a full service of business and commercial finance. As such, if there is anything we can assist you with, please do not hesitate to get in touch.