Understanding an Interest Only Business Loan
When choosing a financial product to start or grow a business, entrepreneurs have many choices available to them. Loans, lines of credit, credit cards, investment, and more are all options that can provide the funding needed. Loans, in particular, come in many different flavors and sizes, and can be a powerful tool that provides financing for immediate business needs like buying or building a facility, upgrading equipment, and getting working capital.
One type of small business loan, called an interest only business loan, is different than the standard “get money, make payments” model of term loans that we all are very familiar with. Lenders still issue funding and still have to be paid back, but the mechanism for making those payments is different and the structure of the loan itself is fundamentally different for both the lender and the borrower.
So, how can you be sure if an interest-only loan is for you? What is the best way for you to get funding for your business? Let’s take a closer look to find out if a standard or interest-only loan is the best choice for your business.
What is an Interest-Only Business Loan?
With a traditional loan, a borrower receives an amount from the financial institution, who is then repaid over a set period of time via regular payments. The payment amount is a combination of the total amount borrowed (the principal), interest, and any fees or other charges that has been split across the agreed upon number of payments (the term).
Simple interest loans, which are the easiest to cover in a short article, front-load the interest into the early payments of the loan term. The borrower’s payments are applied mostly to the interest charges during this period of time and do not start “hitting” the principal amount until much later in the term after the interest has been covered.
When traditional loans are used to buy long-lived, big-ticket items like real estate and commercial buildings, this isn’t a big problem because the asset being purchased isn’t going to depreciate much over the life of the loan and may actually increase in value. Purchases of vehicles, equipment, or other items that don’t hold their value may lead to the borrower becoming “upside down” on the loan, which means that they owe more for the purchase than the item is worth.
On the other side of the spectrum are interest-only loans, which, as the name suggests, only require the borrower to only make payments that cover interest charges in their monthly amount due. At the end of the repayment term, the interest charges are taken care of, but the principal amount remains. The borrower must make a large payment, sometimes called a “balloon” payment, to cover the principal amount and satisfy their obligations for the loan.
Both business loans require the borrower to complete a loan application and meet at least basic requirements before being issued loan funds. Banks and other lenders look at cash flow, credit scores and a credit report, and other documentation like income statements, tax forms, and more. If the lender finds something in the small business owner’s credit history that suggest a problem may arise, they may limit the loan options that are offered or charge more for interest and other fees.
When a borrower receives a traditional loan, interest and principal are broken down and combined to make up the payment due each month. Loans with larger principal balances (what was actually borrowed) and interest rates that aren’t ideal can end up with very large monthly payments – not something many people want to deal with on a regular basis. Even though the principal payments are reducing the amount owed each month, business owners typically want to avoid the giant payments and still get a loan.
Interest-only loans relieve some of the pressure of high monthly payments because the amount due is only related to the interest charges for the borrowed amount. This alone is one of the biggest draws for interest-only loans, as business owners’ monthly outlay is much lower than what it would be with a traditional loan.
Many borrowers may find that, by taking an interest-only loan, they are able to invest the money they would have had to pay for a principal payment in other ways. If the investments are productive, they may even be able to receive a higher rate of return on that money than the rate they are paying on the interest-only loan, which can be a smart business decision. When the full amount of their loan comes due at the end of the term, the borrower will have generated returns on investments to reduce the pain of that large payment.
This benefit may be up for debate, but interest-only loans may allow the borrower to afford a much larger overall loan amount than they could with the more traditional interest and principal payment format. Businesses that are just starting out or that need to quickly grow their operations to meet a new increase in demand may be good candidates for interest only business loans that net them a larger loan amount than they could afford otherwise.
That can be a big boost for a new business, but there are risks attached to larger loan amounts. If, for some reason, the business does not grow at the anticipated rate or there is a downturn in revenues along the way, the business owner or borrower will be stuck with a final payment they might not be able to afford.
Interest only business loans may be viewed as being riskier than a traditional loan. Lenders can see that, even though they are receiving all of their interest payments up front, there is still the matter of the entire principal amount hanging over the borrower’s head. As a result, some lenders may have a policy of charging higher fees or interest rates to cover their risk, which passes some of that pain along to the buyer. This means that ultimately, the borrower is paying more for the privilege of an interest-only loan.
This strategy of risk avoidance also applies to fees and conditions for interest-only loans. Lenders may decide to charge a prepayment penalty for these loans to help them avoid losing money on early payments that reduce the overall amount of interest owed. Prepayment is when a borrower decides to “settle up” early and finish paying off the loan before the term has passed. The costs of administrative efforts and loss of interest revenue for lenders is enough to give them incentive to keep borrowers around for the originally agreed upon term. Fees can be charged with bank loans and from credit unions, and cover things like origination fees, transfers to and from a bank account, late payment penalties, and more.
There may also be cases where a lender and borrower have agreed on a variable-rate interest-only loan, which means that the amount that is owed each month may change with market and economic conditions. This is in contrast to fixed interest rate loan types that hold a steady rate for the life of the loan term. These loans present a unique set of challenges for the borrower, in that their payment amount can be unpredictable and swing wildly if things get ugly in the financial markets. The borrower may also find themselves with much larger payments if rates move in an unfavorable direction.
The temptation of interest-only loans can be strong, but the benefit of lower payments comes with a string attached – a big one, too. At the end of the loan term, the borrower has paid all of the interest, but nothing toward the actual cost of whatever they purchased with the loan funds. This requires them to make a large “balloon” payment at the end of the loan term to cover that amount, which can be quite an undertaking for many small businesses.
If, for some reason, the business hasn’t generated the revenues they’d hoped for during the loan term, or if some other unexpected expenses came up along the way (they always do), the borrower can be on the hook for a lump sum payment they can’t afford. This is a situation that has to be planned for at the beginning of the loan term, which means that the borrower may need to set aside a monthly principal amount as if they were making payments all along. The lender may offer an extension or a refinancing plan for that principal amount, but then the borrower is essentially paying twice for the same loan amount with more interest and fees along the way. This is essentially like taking out a new loan to pay for the previous loan, and is not considered to be a smart way to handle business financing unless all other options have been exhausted.
Is an Interest Only Business Loan the Way to Go?
There are borrowers for whom an interest-only loan is the best choice in lending products. These are businesses that have a need to grow quickly, an established business plan with steady revenue, and a plan for dealing with the balloon payment at the end of the loan term. Interest-only loans are a powerful tool for these businesses, because they allow the owner or borrower to get the funding they need in the short term without the burden of large monthly payments.
Companies that use interest only business loans successfully have been able to plan for the large final payment, have done their research and understand the risks involved, and are able to manage their costs along the way to lock in monthly payment savings. As long as the borrower is able to understand the risks involved and can manage them along the way, an interest-only loan can become a financial tool to save money and grow a business.