Business Loan Terminology You Need to Know

Business Loan Terminology

Business loan terminology can be confusing. Most small business owners would rather grow their companies than talk about loan interest and finance charges. That said, if you approach a lender without knowing loan terminology you could be — well — borrowing trouble.

Fortunately, we’ve created this glossary of loan definitions that a small business borrower must know in order to make informed choices. Knowing these terms will help you understand small business funding options and the obligations that come with them.

Annual Percentage Rate

Annual percentage rate or APR is a calculation used in small business credit products to enable the borrower to compare how much credit actually costs. For example, you could compare the APR on two business credit cards. This gives you a truer comparison of the cost of credit. Don’t confuse APR with simple interest rate. Interest rate refers only to the interest you pay on the money you’ve borrowed. However, APR includes other fees over and above interest. These fees could include origination fees, check processing and maintenance fees.

Amortization

Amortization is the allocation of payments to pay off a loan within the stated repayment period. Amortization schedules apply most of the money in early payments towards paying down the interest. Later, larger potions of each payment go to repay the principal. See an example of an amortization schedule by running our business loan calculator.

Balloon Payment

A balloon payment is a lump sum payment due at the end of a loan term. A balloon payment implies that monthly payments are not enough to pay off the loan in full, but instead a lump sum will be due. Loans with balloon payments are typically short-term loans that keep loan payments low until the term is due.

Borrower

A borrower is a person or business taking money from a bank or other lender with an agreement to repay the loan. The borrower promises to make payments on an agreed upon schedule including interest and other fees. The borrower signs a loan agreement or other debt instruments.

Bridge Loan

A bridge loan is a loan meant to cover expenses until more permanent financing becomes available. In business, bridge loans cover payroll, inventory and other costs. They often have high interest and are intended to be paid off in under a year.

Cognovit Note

A cognovit note is a promissory note where the borrower grants the note holder the right, in advance, to get a judgment without lengthy court litigation. A cognovit note is sometimes called a confession of judgment because the note holder “confesses judgment” on behalf of the borrower, in court, in the event of default. Today, its use is severely curtailed by law. Confessions of judgment notes are legally recognized only in a few states, including Ohio, Delaware, Virginia, Pennsylvania and Maryland. Business owners should know this loan terminology and avoid  cognovit notes because it means giving up valuable rights.

Co-signer

A co-signer is any third party on the hook for loan repayment along with you. A business cosigner is sometimes called a guarantor. The guarantor must sign a document guaranteeing to make payments if you default and cannot pay. An established business owner with good credit usually does not need a cosigner. However, a startup entrepreneur may be required to have one, and should line up potential co-signers such as an established business owner or family member.

Credit Line

A credit line or line of credit is revolving credit that a borrower can borrow from as needed, up to an approved maximum limit. The borrower only withdraws sums as needed, and will be charged interest only on such amounts, not on the maximum approved limit. A loan is different from a line of credit because it requires you to take out the full loan amount at the beginning. With a loan you must pay interest on the full loan funds until fully repaid.

Credit Report

A credit report details the credit history of a borrower or applicant and includes a credit score issued by recognized credit bureaus. For small business loans, lenders often look at the both the owner’s personal credit report and the business’s credit report, among other business loan documents. Credit reports detail the creditworthiness of a person or business. They help lenders decide whether to approve credit and at what terms. Read more in: business credit score.

Debt Instruments

A debt instrument is an agreement between a borrower and a lender saying the borrower will repay the money borrowed or invested. Two examples of debt instruments include the promissory note and the loan. The terms of the promissory note or terms of loan might include interest, collateral and a schedule to repay the loan.

Debt-to-Income Ratio

Debt-to-income ratio refers to the percentage of income a business or individual uses to pay debt. Lenders use this percentage to decide whether a borrower can afford another loan. An entrepreneur may have a student loan and other significant debts. A high debt to income ratio raises questions about whether a person can afford additional monthly payments.

Fair Market Value

Fair market value refers to the property value, i.e., the purchase price of realty or other collateral a buyer would be willing to pay on the open market. The fair market value is calculated by looking at factors like the value of similar property or assets. A mortgage lender will order a property appraisal to determine whether there is sufficient collateral to justify a loan, when collateral is required.

FICO score

The FICO score is a measure used to evaluate an individual’s credit risk for lending purposes. Fair Isaac Corporation of San Jose, California created the FICO score. The score is similar to methods developed by companies like Equifax to measure an individual’s creditworthiness.

Gross Income

Gross income is the total earnings of an individual or business before taxes or costs are subtracted. For individuals, gross income equals your total earnings minus taxes and mandatory deductions. For businesses, gross income refers to revenue over and above payroll, taxes, debt obligations and any other costs associated with operating the business. Net income, by contrast, is after certain costs are subtracted.

Interest Payments

Interest payments refer specifically to the part of the borrower’s monthly payment that goes to pay down interest. Interest payments differ from the part of the payment amounts that go to pay down principal. Interest payments may differ because of amortization. They may be higher at the beginning of a loan but lower near the end.

Loan Commitment

A loan commitment is the name for the agreement a bank or other lender draws up when loaning an individual or business money. Lump sum loans and lines of credit both require these commitments. The same agreements are used for both secured and unsecured loans.

Net Worth

The net worth of a person or business is the difference between what that person or business owns and their liabilities. Some lenders ask for a business owner’s net worth statement, to use as a benchmark to ensure the borrower can afford credit. Use this net worth calculator to calculate it.

Origination Fee

Not all costs associated with a loan are part of the principal or interest. An origination fee is the money the lender charges you to cover the costs of managing your loan.

Personal Guarantee

A personal guarantee is when a business owner personally guarantees in writing he or she will repay a loan if a business doesn’t. However, a personal guarantee is unsecured just like an unsecured loan. As a result, there are no personal assets used as collateral.

Prime Rate

The prime rate is also called the prime loan rate. The prime rate usually refers to a rate published by the Wall Street Journal. Prime rate is used as part of a formula for setting small business loan rates. For example, you may see a small business loan’s rate quoted as “prime + 3.5%.” This means that the interest rate starts with the prime rate and tacks another 3.5%. If prime is 3.25% and you add 3.5%, it means the rate charged will be 6.75% in our example.

Principal and Interest

Principal is the amount of money the borrower borrows. Interest is the amount the lender charges on the loan balance. Principal and interest or P&I usually refers to the monthly payment amount including a portion for principal repayment and a portion for interest.

Promissory Note

A promissory note is a debt instrument you sign agreeing to repay money you borrow. The terms of the promissory note set out the loan principal, monthly payments, repayment period, interest rate and other terms. The promissory note is part of the loan documents, which may include separate covenants, mortgages, UCC filings and more. The lender prepares the promissory note, and usually it is a standard form document. Wording of the note is not usually negotiated.

Refinance Transaction

A refinance transaction involves taking out a new business loan with more favorable terms and using the money to pay off your existing loan. Refinance transactions done correctly help lower the interest rate, lengthen the term or give other favorable terms. Business debt consolidation is similar, but takes multiple debts and combines them into one.

Repayment Period

The repayment period is the time it takes to make all payments due on a loan. The repayment schedule begins with the first payment on the loan and ends when the loan is finally paid off or a balloon payment is due. Another way to describe the end of the repayment period is to say the loan has reached its maturity.

Title Insurance

Title insurance is an insurance policy guaranteeing the title to real estate is clear. A title report protects again liens and claims against real property. An owner’s policy protects the property owner and is part of purchase transactions. A lender’s policy protects the lender in a real property loan transaction. A title company conducts a title search checking unpaid property taxes, liens and other details in the property’s history. A title insurance company writes the policy charging insurance premiums. The lender make title insurance mandatory in any commercial real estate transaction.

Unsecured Loan

If you have good credit, you may be able to get an unsecured personal loan. This is a loan based on your personal creditworthiness. The benefit is you don’t need collateral such as property or other assets. However, you may see a higher interest rate because the loan is a bigger risk for lenders.

What are Common Loan Acronyms?

Business lending uses various loan terminology abbreviations. The table below includes a list of common acronyms used in small business lending.

Acronym Definition
APR Annual Percentage Rate
ARM Adjustable Rate Mortgage
CDC Certified Development Company
CPI Consumer Price Index
DTI Debt-to-Income Ratio
EIDL Economic Injury Disaster Loan
FDIC Federal Deposit Insurance Corporation
FRM Fixed Rate Mortgage
GAAP Generally Accepted Accounting Principles
HELOC Home Equity Line of Credit
LIBOR London Interbank Offered Rate
LTV Loan-to-Value Ratio
MI Mortgage Insurance
MSA Metropolitan Statistical Area
NAICS North American Industry Classification System
NCUA National Credit Union Association
P&I Principal and Interest
PPP Paycheck Protection Program
SBA Small Business Administration
SBDC Small Business Development Center
SCORE Service Corps of Retired Executives

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This article, "Business Loan Terminology You Need to Know" was first published on Small Business Trends



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