Congratulations! Your loan application was approved. Now you sit, pen-in-hand, ready to sign your new business loan contract. You’ve done your due diligence and feel confident that you’ve found the right loan for your business needs. You were pretty sure that, with your application approved, the hard part was behind you, but as you study the contract, the words start to look like they’re from another language — one they didn’t offer in high school … if you’ve been here, you’re not alone. These documents are notoriously filled with legal jargon that can easily lead to confusion.
But don’t worry any longer. This short list of legal terms most commonly used in business loan contracts will equip you with the know-how necessary to review the document with certainty before you seal the deal.
Amortization — literally translated as “to kill it off” — is the paying off of debt over a period of time, with fixed payments according to a schedule. These payments include some interest as well as some principal, so that gradually, as you make amortized payments, you’ll pay off both the loan’s principal balance and the accrued interest. So hack away!
Annual percentage rate, also known as APR, is the true cost of the loan over its full term, including the effects of any compounding interest and fees. APR is different from the stated (or simple) annual interest rate, because the simple annual interest rate doesn’t include compounding interest — i.e. interest on interest, i.e. where it hurts — and may not reflect the true cost of the loan.
Asset-based lending refers to loans that are secured by business assets. For instance, a loan may be secured by your business inventory, accounts receivable, equipment, real estate or other assets.
Business valuation is the process of determining the value of a business for the purpose of selling the business or obtaining financing. Your lender will probably determine the value of your business based on information you provide, such as an income statement, cash flow statement, description of assets and credit report.
Cash for financial reporting purposes is the amount of cash you have on hand, as well as the value of assets that could be immediately converted to cash (such as bank accounts). When it comes to lending, scout’s honor isn’t enough, and your lender needs this information to verify that you have cash on hand to make your loan payments.
Compound interest, also known as compounding interest, is interest calculated on a loan’s initial principal amount, as well as on the accumulated interest of previous payment periods. So if you miss a payment or don’t pay the full amount one month, the interest on future payments will be recalculated based on the full amount you owe, which would then include interest on the missed payment. To put it simply, you will be required to pay interest on the interest.
Debt service is the amount of your required periodic loan payments.
Debt service ratio, determined by your lender, is the amount of cash flow you have available to meet annual principal and interest payments on business loans.
Loan to value is the amount of the loan divided by the value of the collateral (or assets) taken as security for the loan. Determined by your lender, this ratio helps them determine how much money they can loan your business.
Now that you understand these common contractual terms, you can avoid letting legal jargon sway your confidence. With a deeper understanding of the agreement and what it requires, you’re ready to sign your business loan contract and begin the exciting part: using your new cash infusion to take your business to the next level.