We explain the different types of borrowing available to your business
Business borrowing terms explained
When it comes to borrowing money for your business, there are several different options you can choose from. If you’re only just starting out, you may find the various terms and products a little confusing. This quick-start guide outlines some of the most common types of business borrowing and how they work.
- Overdrafts. If a business needs to borrow money on a short term basis, one of the easiest ways to do that is via an overdraft. The most common type is an agreed overdraft facility. This is where your bank gives you a set negative limit you can go into without getting charged. For example, a £2000 overdraft limit means you can use your account up to -£2000 without incurring penalties. However, you may need to pay interest on that amount.
- Business credit cards. Credit cards are convenient, but they tend to be expensive for anything other than short-term borrowing. Usually, you have to repay at least a certain percentage of the amount you borrow each month.
- Bills of exchange. You can also use these for short-term funding, and may also see the term commercial bill to describe them. They allow you to pay a fixed sum of money at a later, predetermined date.
- Business loans. A medium-term form of borrowing. They typically have a term of one to ten years and require regular (usually monthly) repayments until the initial loan and interest have been repaid.
- Mortgages. For longer-term borrowing, you can use a mortgage. A repayment mortgage means you repay an amount towards the principal – the initial amount that you borrowed. If you have an interest-only mortgage, the repayments are lower because you only pay the interest throughout the mortgage term. At the end of the mortgage term, you have to pay back the principal in full.
- Bridge loans. Because mortgages can take time to arrange, sometimes companies use a business bridge loan or a caveat loan. These are short-term loans providing funds while you arrange longer-term finance.
- Convertible loan note. A loan that is convertible into equity. They are generally redeemable as well as convertible.
- Refinancing. This is where businesses use new borrowing to pay off existing borrowing. For example, you could use a consolidation loan to pay off existing loans and credit cards, or a remortgage to pay off existing mortgages or release equity from a property. Companies refinance for various reasons. Sometimes, it can result in more favourable fees or interest rates, or reduced monthly repayments. You may also use them when you switch banks or extend the period of a loan.
The borrowing process
If you’re new to borrowing money for your business, it’s worth knowing how the process works. Below, we’ve outlined the general steps that you’ll have to go through. However, be aware that the exact process will differ depending on the lender and financial product.
- When you apply to borrow money, you will have to undergo a credit check. This will determine how creditworthy you are. In turn, this will determine whether a lender is prepared to lend you money. Additionally, it will affect how much and on what terms they’ll lend you.
- This credit check will examine your credit history. This checks a number of elements, such as whether you have kept up the repayments on any previous credit that you have had. The credit check will result in a credit rating or credit score. The terms adverse credit and sub-prime describe people with a bad credit history.
- The lender may also carry out a stress test. This determines whether the loan is affordable. Several different methods are used depending on what the borrowing is intended to be used for.
- Some forms of borrowing, such as overdrafts and credit cards, are unsecured. Other forms of borrowing, such as mortgages and commercial bills, are secured. With a secured loan, the lender secures the loan on your business property or assets. The property or assets used to secure the loan are the security or collateral, and if you fail to pay the loan, the lender can take possession of them. While the property or assets are being used to secure the loan, they are described as being encumbered assets.
- Depending on your credit rating or score, the lender may require a guarantor or personal guarantees. If someone agrees to become a guarantor or signs a personal guarantee, they become responsible for the repayment of the loan if you fail to make any repayments.
- As part of your application, you may have to pay an arrangement fee to the lender. If you are using a broker, you may also have to pay a broker fee.
Interest is the amount you have to pay to the lender to make it profitable for them to loan money to you. It is calculated as a percentage of the amount you are borrowing. It can take the form of a fixed interest rate which stays the same throughout the loan term or a variable interest rate which can change. Here are some of the essentials you need to bear in mind:
- Lenders use a few different ways to calculate interest rates. For example, some rely on the BBR or the Bank of England Bank Rate. The Bank of England sets this rate each month. Others rely on the LIBOR which is the London InterBank Offered Rate. This is the interest rate that lenders use when they borrow and lend money to each other.
- Some lenders use their own SVR or Standard Variable Rate to calculate the interest. This is not tied to the BBR or LIBOR but follows those interest rates fairly closely.
- A tracker mortgage is a mortgage which tracks one of these interest rates. Sometimes these will take the form of a capped rate mortgage where the interest rate will fluctuate. However, there will be a maximum interest rate that cannot be exceeded, no matter what happens to the interest rate that it is tracking.
- Lenders may also offer a discounted rate mortgage. The discount applies to an introductory period, after which the interest rate reverts to a higher rate. This higher interest rate is called the reversion rate. The introductory period usually lasts between two and five years.
- Lenders calculate interest rates differently depending on the type of borrowing. For short-term borrowing, interest can be calculated daily. For other types of borrowing, lenders may use a monthly or yearly basis to calculate interest. This means that although two lenders might both be quoting the same interest rate in percentage terms, the actual amount of interest they would charge could be different.
- To address this, lenders have to quote an APR or Annual Percentage Rate. This shows you the true cost of borrowing over a year and includes any fees that will be charged. APR gives you the chance to compare different borrowing options.
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