Deciding how to finance your business is probably the most important one you’ll ever make. Over the past decade, the business financing industry has grown to include various options, including the interest-only loan.
For starters, an interest-only loan is a loan in which the borrower only pays the interest payments on the loan amount over a predetermined time frame. At the end of the interest-only loan period, the untouched principal is addressed, either by paying it off completely (a bullet payment) or by making another arrangement. This approach may include applying for another loan or arranging another repayment plan.
Sounds straightforward, right? But like all loans, interest-only loans come with risks. Business owners should be aware of all the red flags before choosing this financing option.
To get an expert’s take on the pros and cons of interest-only loans, we asked a banker, a CEO, and CFO for their insight.
How Can Interest Only Loans Work (or Not) for Your Business?
What a Banker Has to Say
Most flexible financial institutions offer some variation of interest-only business loans to businesses with good credit and robust potential cash flow.
From a banker’s perspective, interest-only loans can keep capital deployed for longer, resulting in more interest paid throughout the loan. Thus, this strategy makes the bank more profitable with only marginally increased risk.
Those with inconsistent cash flow or bonus-based businesses may benefit from an interest-only business loan. This type of loan enables business owners to keep more cash on hand. Then, when business ramps up, they can pay off a portion of the principal in a lump sum.
For a business with fluctuating revenue streams, an interest-only loan gives you a lower monthly loan payment. For example, suppose your business is highly seasonal, and your revenue increases dramatically during the busy season. In that case, you can make extra payments towards the loan during your peak seasons and make lower payments during slower times of the year.
While the determination of your ability to pay back the loan is based on the fully amortized payment, not the interest-only payment, it’s still possible to borrow larger amounts of money. As a result, payments will be lower, which gives you more breathing room in your cash flow.
If you’re considering an interest-only loan, make sure you read the fine print and beware of any accelerated payment covenants or prepayment penalties, which are fees charged when you try to settle the loan before the end of the loan period. Because interest-only loans can be perceived as somewhat riskier for a lender, the requirements for credit scores, down payments, and additional data points may be more strict than those for a traditional loan.
What a CEO Has to Say
Because they don’t feature regular payments towards the principal, -cos-only interest-only loans offer you lower monthly payments over the loan term. This can free up cash flow, enabling you to funnel revenue back into growing your business.
If you believe your income streams will be significantly higher in the future, your business may be an ideal candidate for an interest-only loan.
Since there is no loan amortization, the total interest cost of the loan period will be higher. Making a bullet payment, a lump sum payment made for the entirety of an outstanding loan amount, is more challenging than paying down the loan gradually using amortization. At the end of the interest payment term, you’ll have to face the task of paying off the principal.
If your revenues haven’t increased so that you can afford to pay off the principal or manage traditional monthly payments, you’re in hot water. The bottom line is, before committing to an interest-only loan, make sure that you have a plan in place to deal with the principal.
What a CFO Has to Say
Depending on the loan terms, interest-only payments can keep monthly cash obligations low while allowing the company to make large lump-sum payments when it has extra cash. This gives the company more control over their cash flow and will enable them to invest the money borrowed, put it to work, and start seeing the benefits before making capital payments.
As mentioned by the CEO, a bullet repayment is a lump sum payment made for the entirety of an outstanding loan amount, usually at maturity. But what if the company doesn’t have the lump sum for the bullet payment and cannot refinance? Unfortunately, that scenario could mark the beginning of the end of the company.
In other words, the bullet payment itself could be high risk. To echo the CEO’s insight, making a bullet payment is a more enormous task than using amortization to pay down the loan over time.
Another variant is an interest-free period, such as 12 months on a five-year term loan that allows companies to use the benefits of the lower cash repayments for the 12 months to grow the business by putting the money to use and then amortize the principal over the remaining term of the loan. This de-risks the loan for the bank and removes the need for the company to find a large amount of money to pay off the loan at the end of the term.
As a final note, many large expenses for your business, such as office equipment and technology hardware, can depreciate. Therefore, if the finance is used to purchase these items, you’ll end up owing more than the depreciated value of these assets.
Shop Around, Strategize & Evaluate Your Options.
When it comes to business financing, there’s a lot at stake if you make the wrong choice. That’s why it’s best to give yourself some time for serious research. It pays to shop around, strategize, and evaluate your options to determine which loan works best for your business.
Seeking a finance partner that can help? To explore your options, talk to us.