Common Types of Bank Loans
With myriad varieties of loans and financing options available from banks of all sizes, you'll need to know the which is option is best for you.
Much like trying to pick the right loan for a home mortgage, you'll
likely be overwhelmed by the many types of small business loans your
bank makes available.
And, much like a mortgage, one loan option usually floats to the
surface as the best fit for you and your situation. Discerning which
loan is the right choice isn't necessarily a matter of one type being
better than the other.
Focus on the two of major characteristics that vary among bank loans:
- the term of the loan
- the security or collateral required to obtain the loan
Understanding Loan Terms
The term of the loan refers to the length of time you have to repay
the debt. Debt financing can be either long-term or short-term.
Common Applications for Long-Term and Short-Term Financing
Long-term debt financing is commonly used to purchase, improve or
expand fixed assets such as your plant, facilities, major equipment and
If you are acquiring an asset with the loan proceeds, you (and your
lender) will ordinarily want to match the length of the loan with the
useful life of the asset. For example, the shelf life of a building to
house your operations is much longer than that of a fleet of computers,
and the loan terms should reflect that difference.
Short-term debt is often used to raise cash for cyclical inventory needs, accounts payable and working capital.
In the current lending climate, interest rates on long-term financing
tend to be higher than on short-term borrowing, and long-term financing
usually requires more substantial collateral as security against the
extended duration of the lender's risk.
Key Differences Between Secured or Unsecured Debt
Debt financing can also be secured or unsecured. Unfortunately, these
terms don't mean how secure or unsecure the debt is to you, but how
secure or unsecure the debt is to the lender.
The Price of Secured Loans
No matter what type of loan you take, you promise to pay it back. With a secured loan, your promise is "secured" by granting the creditor an interest in specific property (collateral) of the debtor (you).
If you default on the loan, the creditor can recoup the money by
seizing and liquidating the specific property used for collateral on the
debt. For startup small businesses, lenders will usually require that
both long- and short-term loans be secured with adequate collateral.
Because the value of pledged collateral is critical to a secured
lender, loan conditions and covenants, such as insurance coverage, are
always required of a borrower. You can also expect a lender to minimize
its risk by conservatively valuing your collateral and by lending only a
percentage of its appraised value. The maximum loan amount, compared to
the value of the collateral, is known as the loan-to-value ratio.
A lender might be willing to lend only 75 percent of the value of new
commercial equipment. If the equipment was valued at $100,000, it could
serve as collateral for a loan of approximately $75,000.
Revolving Debt and Unsecured Loans
In contrast with secured loans, your promise to repay an unsecured loan is not supported by granting the creditor an interest in any specific property.
The lender is relying upon your creditworthiness and reputation to
repay the obligation. The most ubiquitous form of an unsecured loan is a
revolving consumer credit card. Sometimes, working capital lines of
credit are also unsecured.
While your property may not be at direct risk, defaulting on a
secured loan does carry serious consequences. True, the creditor has no
priority claim against any particular property if you default, but the
the creditor can try to obtain a money judgment against you.
Unfortunately for startups, unsecured loans (at least ones with
reasonable interest rates) aren't usually available to small businesses
without an established credit history.
An unsecured creditor is often the last in line to collect if the
debtor encounters financial difficulties. If a small business debtor
files for bankruptcy, an unsecured loan in the bankruptcy estate will
usually be "wiped out" by the bankruptcy, but no assets typically remain
to pay these low priority creditors.
Types of Bank-Offered Financing
Now that you're familiar with the most important aspects of bank
loans, it's important to become familiar with the most common types of
loans given by banks to startup and emerging small businesses:
- working capital lines of credit for the ongoing cash needs of the business
- credit cards, a form of higher-interest, unsecured revolving credit
- short-term commercial loans for one to three years
- longer-term commercial loans generally secured by real estate or other major assets
- equipment leasing for assets you don't want to purchase outright
- letters of credit for businesses engaged in international trade
Working Lines of Credit and Credit Cards
A line of credit sets a maximum amount of funds available from the bank, to be used when needed, for the ongoing working capital or other cash needs of a business.
Consider a line of credit a loan that functions like a checking
account. In most cases you'll receive a checkbook for your line of
credit so you can write checks on the fly without dipping into your own
cash. Some may offer debit cards, or you can visit the bank to
withdrawal cash. It is, of course, still a form of financing that must
be repaid with interest.
Common Terms for Lines of Credit
As you consider a line of credit, you'll find most fall within these broad categories:
- Lines are typically offered for renewable periods that range from 90 days to several years.
- Extended periods are usually subject to annual reviews by the lender.
- Maximum amounts vary greatly, from $10,000 to several million dollars.
- Interest rates usually float, and you pay interest only on the outstanding balance.
Most small business owners typically use their lines for daily
operations, such as inventory purchases, and to cover periodic or
cyclical business fluctuations. Collateral for the loan is often accounts receivable or inventory.
From a lender's perspective, the adequacy of your cash flow is the
most critical consideration. A commitment fee may be assessed by the
bank for making a line of credit available to the borrower, even if the
full amount is never used. Established businesses with sound credit
histories have the best bet of obtaining unsecured revolving lines of
A commercial line of credit can, for better or worse, become an "evergreen" never-ending debt to a small business.
A Cautionary Tale: The "Evergreen Credit" Trap
Frequently, a small business will open a working line of credit of,
for example, $40,000. Because of the immediate cash needs of the
business, the credit line is quickly topped out. To make matters worse,
the borrower's continuing cash shortage forces it to pay only interest
on the loan, and the principal is not reduced.
Commonly, lenders review working capital lines of credit annually,
either renewing them or calling them due. While lenders typically want
the line of credit to carry a zero balance at some time during the
annual period, the competitive banking environment may lead a bank to
continually renew a maximized line of credit as long as the institution
is receiving timely interest on the loan.
This behavior leads to evergreen lines of credit becoming, in effect,
indefinite term loans with a balloon payment of principal that poses
risks to both the lender and the borrower.
Lines of credit are a wonderful way to help entrepreneurs build their
business. But like any form of revolving credit, they must be used
Financing Through Credit Cards
Although credit cards are not a financing device exclusive to
commercial banks, they are often a part of a bank's lending portfolio. A
revolving credit charge card can used by a business as an alternative
to a working line of credit.
The competitive banking environment has forced many institutions to
seek new sources of income and develop new financial products that meet
changing demands. One of the less publicized developments has been the
growth of the small business credit card.
The Basics of Small Business Credit Cards
The largest card issuers—VISA International, American Express and
MasterCard International—have adopted small business card programs. As
a source for working capital, revolving credit cards offer a quick
source for limited funds.
However, their convenience is costly. Cards typically offer an
interest rate slightly less than the rate on individual consumer cards
and have lending limits that average just over $15,000.
To make the cards more attractive to prospective users, the lenders
generally package credit along with additional features such as:
- discounts for rental cars, hotels and gas
- travel insurance
- warranty extensions on purchases
- variety of different types of insurance
You should be prepared to present both a personal and business credit
history when applying for the cards. And, much like lines of credit, be
leery of over-reliance on this form of credit.
Short- and Long-Term Commercial Loans
Aside from revolving forms of credit, banks can provide commercial
loans similar to what you might have experienced getting a mortgage.
(Well, hopefully not quite as painful.)
Commercial loans, available in short-term and long-term forms, are
similar to traditional consumer loans. And, if you're not interested in
purchasing a big-ticket item that would require a loan, you can always
consider commercial leasing.
Financing Through Short-Term Commercial Loans
Although short-term commercial loans are sometimes used to finance
the same type of operating costs as a working capital line of credit,
they're not interchangeable. A commercial loan is usually taken out for a
specific expenditure (for example, to purchase a specific piece of
equipment or pay a particular debt), and a fixed amount of money is
borrowed for a set time with interest paid on the lump sum. In essence, a
commercial loan is close to the loans you're most familiar with, like
student loans, home loans, etc.
For nearly all startup businesses—and most existing businesses—a short-term commercial loan from a bank must be:
- secured by adequate collateral
- supported by a reasonable cash flow and a regular sales history
A fixed interest rate may be available because the duration of the loan,
and therefore the risk of rising rates, is limited. While some
short-term loans have terms as brief as 90-120 days, the loans may
extend one to three years for certain purposes.
As far as what qualifies for adequate collateral, accounts receivable or inventory, as well as fixed assets, usually qualify.
For startups and relatively new small businesses, most bank loans will be short-term.
Rarely will a conservative lender like a bank extend a commercial
loan to this type of borrower for more than a one- to five-year
maturity. Exceptions may exist for loans collateralized by real estate
or for third-party (e.g., SBA) guaranteed loans.
Financing Through Longer-Term Commercial Loans
As the name implies, long-term commercial loans are generally repaid
over more than one to three years. Because more time for you to repay a
loan equals more risk for the bank extending the loan, long-term
commercial loans are typically more difficult for smaller businesses to
With small businesses, a lender may not be willing to assume the risk
that the business will be solvent for, say, 10 years. Consequently,
banks will require collateral and limit the term of these loans to about
five to seven years. Occasionally, exceptions for a longer term may be
negotiated, such as loans secured by real estate.
The purposes for longer commercial loans vary greatly, from purchases
of major equipment and plant facilities to business expansion or
acquisition costs. These loans are usually secured by the asset being
acquired. Additionally, financial loan covenants are regularly required.
Some small business advisers discourage the use of debt financing for
fixed assets, particularly long-term assets such as equipment, office
space or fixtures. They suggest that the cash-flow problems of small
businesses require that borrowed money be directed to generating
immediate revenue through expenditures relating to inventory and
Buying a new expensive piece of machinery may take many years to pay
for itself. Instead, you should aim to obtain a high rate of short-term
return on every cash investment, and do whatever you can to minimize the
costs of fixed assets by leasing, buying used equipment, sharing
Financing Through Equipment Leasing
From a bank's perspective, the leasing business can take the form of either:
- a loan that the borrower uses to lease equipment from an independent source
- a direct lease from a bank subsidiary company that owns the equipment
The duration of the loan is tied to the lease term.
Assets commonly leased by small businesses include equipment,
vehicles, real estate or facilities. Most banks require a solid
operating history before engaging in leasing agreements with small
Letters of Credit
As with many aspects of international business, the game changes. And
that sentiment holds true for financing a company with international
ties. When you're business deals wit issues abroad, you'll likely need
letters of credit.
Letters of credit are not the most common means of small business
financing, but they are an important financing tool for companies that
engage in international trade.
A letter of credit (LC) is simply a guarantee of payment upon proof
that contract terms between a buyer and seller have been completed. LCs
are just fancy, two-way IOUs often used to facilitate international
How Letters of Credit Work
In their most basic forms, obtaining letters of credit involves three steps:
- You, the buyer, go to your bank to request a letter of credit.
- The bank will grant your letter of credit only if you have an adequate line of credit established their.
- On your behalf (and for a fee), your bank promises (via the LC)
to pay the purchase price to a seller (or his or her appointed bank) if
stipulated and highly detailed conditions are met.
These conditions might include any or all of the following:
- complete, on-board, ocean bills of lading
- commercial invoice, original, six copies
- packing slip, original, six copies
- insurance certificates
- inspection certificates
- strict date limitations
- precise name, and address of the beneficiary (seller)
- references to mode of transport
- dozens of other conditions covered by the "Rules"
What are these "Rules" we speak of? They were drafted by the
International Chamber of Commerce (ICC) in 1933 and revised as recently
as 2007. They govern a standard letter of credit format accepted
internationally and are known as the "Uniform Customs and Practice for
Commercial Documentary Credits (UCP)."
Your Bank's Role in Making Your Purchase
Your bank works as a kind of transfer agent, usually with the seller's
bank, to exchange the purchase price for title or claim to goods. The
parties thereby use their banks as intermediaries to limit the risks of
doing business with foreign trading partners. These risks include
foreign currency exchange rate fluctuations as well as frequent shipping
delays, not to mention the perils inherent in international trade.
Letters of credit are available in a variety of forms, including:
- confirmed irrevocable letters of credit
- confirmed letters of credit
- acceptance letters of credit
- back-to-back letters of credit
Each demands differing degrees of bank commitment, but, generally speaking, you will only be dealing with irrevocable LCs.
If you are the importer, for example, you need to be assured that the
proper goods will be delivered to you intact, on a date certain, in
good condition and at the agreed-upon cost. The sellers (exporters) need
to know that when they comply with all the terms you've set forth in
the letter of credit, they'll be paid the amount due in a timely manner.
And everything must be thoroughly documented at both ends.
Keep in mind that banks deal with documents, not goods, and if the
documents are incorrect—even if the goods arrive as promised—the
letter of credit can be worthless if any party to the agreement has made
a mistake in the paperwork. The converse, of course, is that the
paperwork can be perfection personified and the LC therefore honored , but the wrong goods might be delivered. That's why you need to have an
inspector (a customs broker, freight forwarder, etc.) certify what you
ordered is what was shipped and that it arrived in good shape.
The Importance of Detail
The key point to remember about LCs is the need for precision.
Attention to detail and nit-picking legalese are mandatory. If an error
is made or adjustments are needed subsequent to the issuance of an LC,
amendments can be made to accommodate all parties to the transaction.
But banks will follow these instruments to the letter so you need to be
as concise and accurate as possible when specifying terms.
The devil, as usual, is in the details, but the security an LC
provides to both buyer and seller is well worth the effort involved.
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