Small business bank loans totaled nearly $600 billion in 2015, according to data from the U.S. Small Business Administration reported in U.S. News: “At the same time, lending from alternative sources such as finance companies and peer-to-peer, or P2P, marketplace lenders amounted to $593 billion.”
For some small business owners, borrowing money taking on debt can be a nerve-racking exercise. The business owner may have to put personal possessions, such as their homes, their cars, or other assets up as collateral for the loan. But being a smart business owner means that while you may take out loans and acquire debt, it is important to make sure that such loans can be paid back through your business activities.
This is where your debt-to-income ratio (DTI) comes into play. You can calculate DTI by dividing your business’s monthly total recurring debt by your gross monthly income. DTI is typically expressed as a percentage.
For example, if you want to purchase a newer, bigger property for your business, and your business generates some $100,000 per year in profits, it may be reasonable to purchase a property that costs $200,000; however, it might be problematic for you to purchase a property that costs $20,000,000.
Having a low debt-to-income (DTI) ratio is ideal. A low DTI typically means that your business isn’t highly leveraged. It is also an indicator that your business would be able to survive in the event that your sales slumped. However, if you have a high DTI, you would be very much in trouble in the event of a recession or if your industry or business experiences a sudden major slowdown. A 43% DTI is typically the highest ratio that a person can have if they are applying for a mortgage; anything higher would be too risky for a bank to take on. For small businesses this is a good rule of thumb too.
Solutions for all businesses
There are many types of loans that your small business can take out that will allow you to keep your DTI in check so you don’t go overboard and find yourself swimming in an endless stream of debt. Here are examples of some specific types of loans that might benefit your business, depending on your business’s need:
1. Equipment Loan
If you run a construction business that requires you to purchase a bulldozer, you can likely purchase the product with an equipment loan. Typically you will have to make a 10% to 20% down payment. And, the equipment itself could very well be your collateral. Your loan could come from a direct lender or from the equipment manufacturer itself.
2. Commercial Mortgage Loan
If you are looking to purchase, develop or even refinance property for your business, such as a warehouse or a storefront, you can take out an SBA loan, similar to a residential mortgage. As U.S. News reports, “Loans that are guaranteed by the Small Business Administration are usually 2 to 2.5 percent higher than the prime residential mortgage rate.”
3. Business Credit Loan
Similar to how credit cards work, you receive a maximum amount of money that you can borrow. A strong selling point for business credit loans is that you can use such credit for any business need. This means you may not feel limited and may be able to sprinkle money across many business verticals from leasing property to purchasing supplies.
4. Invoice Finance Loan
If cash flow is a major problem for your business because you have performed services or sent out goods that haven’t been paid for yet by your customers, you can finance this through companies that will cover your gaps in invoicing for a fee and interest.
Also remember, you can take out loans that have to be paid back in varying increments of time. If you don’t anticipate your business being profitable for a few years, you can take out a medium-to-long-term loan. Loans with these terms may get you through your initial period of setup. They can also help you make payments to your staff or cashflow required assets. Typically with longer term loans you repay less money per month because payments are spread over a longer period. But, you must remember that interest compounds over time. So, in the end you will be paying more money in interest with a longer term loan.
Of course it may be beneficial to shop around to make sure you are getting the best rates. It is also important to note that with a low debt-to-income ratio it will be significantly easier for you to attract loans at interest rates that aren’t exorbitant.