Almost everyone needs financing at some point in their lives for several reasons.
In your case, you probably need a loan to start or expand your business. Business or personal loans are among the most viable financing options that many start-ups or entrepreneurs turn to. But though they are now accessible nearly everywhere, finding the most fitting one can be complicated.
When taking out a loan for your business, you will have to take into account the structure of the loan. Numerous factors may come into play when deciding on this matter, and the loan rates are among them. You can either opt for a variable or fixed rate for your loan. But whichever you choose, there are always some pros and cons.
Here, we’ll explore the importance of a good loan structure, the role of rates, and whether or not variable rate loans are the right option for your business.
Understanding Loan Structure and Its Importance
It is essential to think about how you are going to structure your loan to best serve your business. Doing so can help you save a lot of money, time, energy, and even unnecessary problems in the future.
Basically, loan structure is the terms that make up your loan. Lenders usually set up their loan products to accommodate borrowers’ needs with less financial risk on their part. You can then expect that loan structure may greatly vary from every lender and borrower since each one has different standards and needs.
Nevertheless, here are some reasons why a good and proper loan structure is essential when you need financing for your business.
1. Accomplish Purpose
There is a wide range of loans available in the market. But not all will spontaneously meet your business and fit your resources.
If your loan doesn’t fulfill what you intended to achieve in your business, you can put your finances at risk. A loan that will enable you to accomplish your business goals will most likely require the right structuring.
2. Adequate Loan Amount
The loan amount is a critical element for good loan structuring. In order to achieve the purpose of your loan, it should be at least adequate but not too much.
A loan that’s too little can be deterring since it doesn’t serve your business goals or needs. But an excessive one may also create problems in repaying the loan. Thus, your loan must be structured with an accurate amount.
3. Appropriate Cost
It’s worth pointing out that your loan isn’t free money. In addition to the loan amount, there are fees and interests that you need to pay. If the loan is not well structured, you may be charged beyond what your business can comfortably afford.
But structuring your loan by your business’s financial needs and capacity can result in the most reasonable cost possible.
What To Consider When Structuring Your Loan?
On the lender’s part, loan structuring is generally about customizing their loan products for the borrower’s needs.
However, most people seeking a loan, whether for personal or business purposes, tend to treat the whole process as a transactional sale. They often make quick decisions and don’t know what to ask regarding their loan structuring options.
That is why many miss out on potential savings and better deals in their loan. It must be noted there isn’t one steadfast rule in structuring one’s loan that is applicable for every scenario. But there are features which you should not overlook.
The interest rates are one of the most critical aspects of your loan. Because regardless of the amount and type, they significantly impact the overall borrowing cost of your loan. But note that the interest rate you pay on a loan usually depends on several factors, such as credit rating, payment history, and type of rates.
That said, you have two primary options when structuring your loan based on interest rates, and we are highlighting them both below.
i). Fixed Rates
Fixed rates do not fluctuate regardless of what the market interest rates do. When you take out a loan with a fixed rate, your monthly payments remain the same over the entire life of your loan.
Since it is also predetermined, you would already have an idea of your loan’s interest rate at the time of approval.
ii). Variable Rates
On the other hand, variable rates can either move up or down, depending on the market’s current conditions.
Because of the interest rate changes, you can expect that your monthly payments also vary every month. You can either be paying more one month and less another month.
Variable-Rate Loans As An Option
Variable-rate loans have become more appealing for small businesses. One reason is that business owners can borrow money at an interest rate that changes now and then.
In fact, historical trends show that the borrower is likely to pay less interest on a variable rate loan than on a fixed rate one in the long run.
But still, there’s no guarantee that it will work the same for every business all the time. To help you make a more informed decision, have a look at the potential benefits and drawbacks of variable rate loans. This way, you’d be able to weigh your options.
Benefits of variable rate loans
A variable rate loan can be an excellent choice because of the following advantages:
1. Lower Starting Interest Rate
The starting interest rates of variable-rate loans are likely to be lower than the fixed-rate ones. In some instances, such rates are not subject to adjustments for a few months or even years. Because the introductory interest rate is lower, your monthly payments also start lower.
2. Interest Rates Could Go Down
With variable loans, there is always a possibility that lenders will reduce the interest rate on your loan. Thus, you can further expect that your loan’s total amount and monthly payable will also decrease.
If you pay back the loan before the low rate is over, a variable rate loan would be incredibly beneficial.
3. Flexible Repayment
Another good thing about variable loans is the wide range of repayment methods it offers. You can repay your loan off faster without running up interest rate break costs.
Thus, it is easier for you to refinance and switch to a different lender or loan product. Some variable-rate loans will allow you to reduce the balance of the loan you are paying while you can access surplus funds.
Drawbacks of variable rate loans
Like other types of loan, variable rate loans come with disadvantages, and they are highlighted below:
1. Interest Rates Could Go Up
Unfortunately, the interest rates in variable rate loans could also go up. If that happens, you could end up paying a lot more on your loan’s monthly repayments and the total amount payable.
Although it can stay on a downward trend for a few months, it can rise dramatically without warning the next month.
2. Uncertain Cash Flow
Because rates in variable rate loans fluctuate anytime, it would be challenging for you to make a forecast of your cash flow over the long term. Remember that a good cash flow is vital to keep your business afloat.
Hence, a variable rate loan might be hard to keep up, especially if there are unexpected financial concerns in your business.
3. Get Stuck On The Loan
You would always be dealing with uncertainty in variable loans, making it harder for you to plan your budget or assess the total borrowing costs.
Although you are planning to make extra payments to repay your loan faster, several unexpected events may also arise. With fluctuating rates and payables that could become too expensive, you can get stuck on the loan.
Should You Choose A Variable Rate Loan For Your Business?
It is not easy to choose a structure for your loan. Whether or not you go for a loan with a variable rate is entirely up to you.
But to help you make the most appropriate decision for your business, the following questions might be worth considering:
- Do you want to save a lot of money in interest even if your monthly payment is unpredictable?
- Is the cash flow in your business enough to handle larger monthly payments for an uncertain period?
- Do you have other financial cushions when unexpected events come up?
- Is flexible repayment works better for your business’s goals and conditions?
- Are you planning to pay back the loan within a short period?
If your responses to the questions are “yes,” a variable-rate loan may be an excellent option for your business. However, bear in mind that your business must have an adequate financial cushion and positive cash flow to maximize the benefits of a variable loan.
It would be best to further evaluate your risk tolerance and budget before going for this option. Remember that rates are only one component of your loan’s structure. Also, don’t hesitate to ask for financial advice from experts.
To wrap things up…
There is no one-size-fits-all loan for every business. Each comes with some advantages and downsides. But if you want to minimize the risks, it’s always important to consider all the possible options before you commit to any loan.
Even if most borrowers benefit from a variable or flexible rate, it isn’t necessarily the best one for you. Take a chance to first evaluate your needs and resources.
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Kendra Miller is a freelance writer whose niche is in the area of business and finances. In her writings, she often tackles how essential it is to keep a watchful eye on the interest rate changes. She believes that every entrepreneur must be well-equipped to timing their investments.