Advantages and disadvantages of bank loans
A loan is an amount of money borrowed for a set period within an agreed repayment schedule. The repayment amount will depend on the size and duration of the loan and the rate of interest.
Loans are generally most suitable for:
- paying for assets - eg vehicles and computers
- start-up capital
- instances where the amount of money you need is not going to change
The terms and price of loans will vary between providers and will reflect the risk and cost to the bank in providing the finance. For larger sums, the pricing and terms may be negotiable.
Banks will loan money to businesses on the basis of an adequate return for their investment, to reflect the risks of defaulting and to cover administrative costs. If you have an established relationship with your bank, they will have developed a good understanding of your business. This will help them to advise you about the best product for your financial needs.
Different types of bank loan include:
- working capital loans - for short notice or emergency situations
- fixed asset loans - for buying assets where the asset itself is collateral
- factoring loans - loans based on money owed to your business by customers
- hire purchase loans - for long-term purchase of assets such as vehicles or machinery
Advantages of term loans
- The loan is not repayable on demand and so available for the term of the loan - generally three to ten years - unless you breach the loan conditions.
- Loans can be tied to the lifetime of the equipment or other assets you're borrowing the money to pay for.
- At the beginning of the term of the loan you may be able to negotiate a repayment holiday, meaning that you only pay interest for a certain amount of time while repayments on the capital are frozen.
- While you must pay interest on your loan, you do not have to give the lender a percentage of your profits or a share in your company.
- Interest rates may be fixed for the term so you will know the level of repayments throughout the life of the loan.
- There may be an arrangement fee that is paid at the start of the loan but not throughout its life. If it is an on-demand loan, an annual renewal fee may be payable.
Disadvantages of loans
- Larger loans will have certain terms and conditions or covenants that you must adhere to, such as the provision of quarterly management information.
- Loans are not very flexible - you could be paying interest on funds you're not using.
- You could have trouble making monthly repayments if your customers don't pay you promptly, causing cashflow problems.
- In some cases, loans are secured against the assets of the business or your personal possessions, eg your home. The interest rates for secured loans may be lower than for unsecured ones, but your assets or home could be at risk if you cannot make the repayments.
- There may be a charge if you want to repay the loan before the end of the loan term, particularly if the interest rate on the loan is fixed.
When loans are not suitable
It is not a good idea to take out a loan for ongoing expenses, as it may be difficult to keep up repayments. Ongoing expenses are instead best funded from cash received from sales, possibly with an overdraft as backup.
If you cannot obtain a loan or other type of finance from your bank, there are other finance options available to you. For more information, see business financing options - an overview.
If you believe that a bank loan may be a viable option for your business, see prepare your business for bank financing.