As a small business owner applying for a business loan, there are a few things you should consider before you start looking for the right lender and small business loan product.
The first item on your list should be the purpose of your loan – how will you use the money. The next one is what the loan amount should be. These should be followed by the interest rate you’re willing to accept and the loan repayment period that works for your business finances and growth needs.
Today, we’re going to discuss loan tenors – whether your business needs a short-term or a long-term small business loan.
What is a small business loan tenor?
A loan tenor is the repayment period for which you get the business loan. For example, if you get a business loan for 2 years, your loan tenor is 24 months (2 years). If your EMI payments are on a monthly schedule, you need to make 24 EMI payments over the next 2 years to repay the loan amount (principal + interest) that you borrowed from your lender.
In general, short-term loans tend to have higher EMIs compared to loans with longer tenors. This is because with longer-term loans you have more EMI instalments to divide the loan amount and interest due.
What factors do I consider when determining if a short-term or a long-term business loan is better for my small business?
1. The regularity of your cash flow
If you have a regular cash inflow, meaning you know for sure that you will have a certain amount of money coming into your business bank account every month, a short-term loan is right for your small business financing needs. This is because if you know for sure that you’ll have the money to pay your EMI every month, and you don’t have to worry about delaying the payment or paying the lender a smaller amount for every EMI instalment.
On the other hand, if you’re just starting out or your work doesn’t guarantee a stable monthly cash inflow, a long-term loan may be better for your needs. With a longer loan repayment period, you can space out your payments over more time and have to pay the lender smaller EMIs every time.
2. Your interest-bearing capacity
Related to your cash flow, this factor determines how much interest your small business can accommodate.
Let’s consider this example: You’re getting business financing of Rs. 10,00,000 at an interest rate of 20%. Now your lender offers you a 1-year or a 2-year loan tenor. Which one is the better option for you in purely financial terms?
Your monthly EMI instalment for the 1-year repayment period will be Rs. 92,635, and your monthly EMI instalment for the 2-year repayment period will be Rs. 50,896. Now on the face of it, the longer loan tenor seems like a better option because you’ll owe the lender less money every month.
However, if you consider the business financing in terms of only the loan interest, you will be paying the lender Rs. 1,11,614 in interest alone when you get the loan for one year. Meaning at the end of 1 year, you will owe the lender Rs. 11,11,614 for a Rs. 10,00,000 business loan.
|Loan Amount||Interest Rate||Loan Tenor||Monthly EMI||Interest Payable||Total Payment|
|Rs. 10,00,000||20%||12 months||Rs. 92,635||Rs. 1,11,614||Rs. 11,11,614|
On the other hand, when you take the same loan amount at the same interest rate for a tenor of 2 years, you end up owing the lender Rs. 2,21,469 in interest. So, at the end of 2 years, you will owe the lender Rs. 12,21,496 for a Rs. 10,00,000 business loan!
|Rs. 10,00,000||20%||24 months||Rs. 50,896||Rs. 2,21,496||Rs. 12,21,496|
Therefore, a long-term loan may seem attractive at first because your monthly EMI is lower, but over time, you end up paying the lender a lot more in interest.
So, when you’re deciding whether a short-term or a long-term loan tenor is better for your small business financing needs, consider whether your business will be able to handle the trade-off between paying more every month in the short-term versus paying less every month but paying more overall.
3. Your usage of the funds
Finally, you need to consider what you will be using the small business financing for.
If you’re taking the business loan to fund your business expansion plans or diversify your business, it is unlikely that the expansion will start making money immediately. After getting the business financing, it’ll take you a couple of months to set up the new operation, test your business plan, and adjust your processes as you learn. Maybe after 6-8 months, you may start to see a steady flow of income, and it may take a few months still for the expansion to turn a profit.
For this purpose, a long-term loan tenor is a better option so that you don’t owe the bank a large amount of money every month even though you’re still setting up shop.
Alternatively, if you’re taking a Working Capital Loan and you’re using it to purchase new material and inventory for your business, this addition may pay off immediately and bring in more cash. In this case, a short-term loan tenor is better because you’re sure the addition of these other goods will increase your sales and bring in more profits.
When you’re getting small business financing, thinking strategically about all aspects of the loan will help you make a fully informed decision that will be the best for your business in the long run.
At CreditEnable, part of our mission is to help small business owners better understand the underwriting process so that you don’t miss out on any important information which may prove critical for your business.
When you apply for small business financing with us, we assess your business finances and compare them to your business needs to match you with the right business loan product and lender who will offer you a loan amount, interest rate, and loan tenor that work for you.
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