At Able, we believe that “if your business can get a bank loan, it should” (assuming, of course, the loan term, loan size, and timing fit your needs).
Why do we say that?
Because a bank's interest rate is going to be cheaper than the best alternative lender's rates.
Why? Well, it's not because banks are great and other small business lenders are a rip-off. It’s because of the fundamental different underlying economics of bank lending.
Understanding Interest Rate
The “interest rate” on any small business loan is a combination of three factors:
- "Cost of capital,” i.e., how much it costs for the lender to get the money
- "Risk adjustment,” i.e., how much the lender needs to charge to offset losses
- "Spread" (sometimes called “net interest margin”), i.e., any additional amount charged by the lender in excess of the cost of capital and risk adjustment
So why are banks so competitive in their pricing? Actually, a few reasons.
First, banks have very low cost of capital. That's because banks are sourcing money from different channels than most other lenders.
Most lenders get money from investors who give them money expecting to earn a return (usually in the 6 to 8% range). It's a relatively safe, lower-yield investment.
Most banks, by contrast, get money from depositors (people like you and me) who give their money at the bank because it's a safe, secure way to store and transmit money. They're not expecting much (if any) return on their money. They just want their money to be safe. And it is, because bank deposits are guaranteed by the Federal Deposit Insurance Corporation.
Second, banks have much lower risk adjustments than most other lenders. That's because they're only making the safest loans.
Banks can’t just make a small business bank loan to any Tom, Dick, or Harry. They have to be extremely stringent about who they lend to, because banks are lending depositors’ money and small business loans are notoriously risky—and the economics aren’t that great. (Those who are curious can learn more about that here.)
So as a result, banks only lend to the safest businesses. They want strong affordability, full collateralized loans, several years of historical success, and near pristine credit.
So What? Can I Get a Bank Loan?
So the $64,000 question for most small business owners in the market for a small business loan is whether they qualify for a low-interest bank term loan. Put simply, they ask: “Can I get a bank loan?”
That’s a tough question to answer definitively, and the answers will vary from bank to bank and from product to product.
(Side bar: it’s a lot easier to qualify for a small line of credit for less than $100,000 than for a larger small business term loan over $100,000. LOCs are great for short-term working capital and inventory financing, and are a great alternative to factoring. But they’re not a great tool for long-term financing. Read more here.)
But in general banks look at the “Five Cs” of credit:
Are they comfortable with your character?
Lending money is risky because not everyone feels obligated to repay.
So banks want to see a good credit score (business credit and personal) and strong payment history, especially on any existing business loans. Typically, this means super-prime personal and business credit (at least 680, but more realistically 800+), no late payments or defaults, and several years of operating history upon which to base their judgments.
Are they comfortable that you’re capable of repaying the small business loan?
Loans need to be repaid (“serviced”), and you can only do this if you can afford the debt payment.
So banks want to see several years with at least $1-2 million in annual revenue ($3 million or above is ideal) and at least 2 years of bottom-line profitability. There are also a variety of ratios to determine affordability.
The most important metric is debt service coverage ratio. It basically needs to be above 1.15 or else your chances of getting a bank loan are nearly zero.
Are they comfortable with your investment in your small business?
This breaks out along two lines: money-in and cash-on-hand.
Money-in: The nature of small business loans is that it’s easier to walk away from them if the economics don’t make sense.
So banks want to see that you’re deeply invested in your small business and its success. This is a function of how much “equity” you have in your business, after subtracting out any debts. (They don’t want you to be underwater in your business!)
Cash-on-hand: Lots of small businesses fail not because they’re bad businesses but because they fail to properly plan for cash-flow issues (more on that here).
So banks want to see that you have enough personal and business assets (liquid or liquidatable) to absorb any unexpected cash-flow shocks.
Are they comfortable with their ability to recoup their loan in bankruptcy?
In America, people can typically discharge most or all of their debts through our bankruptcy system (a nice alternative to debtors’ prison). But bankruptcy gets a little hoary for lenders: the general rule is “first lien creditors get paid, second lien creditors get something, unsecured creditors get nothing.”
Banks want to see that you have enough assets to cover the loan in the event of bankruptcy. The rule of thumb is they want to see collateral sufficient to cover the loan (assessed at book value). If you don't have enough collateral, you might have to go the SBA route.
Are they comfortable with industry and market conditions?
Some industries are better than others (for lenders). For instance, shellfisheries are terrible (highest default rates!). And some markets are better than others. For instance, no one wanted to be a lender in 2007-2009.
So banks are looking for industries with well-understood business models and strong repayment histories. New business models (new products, technology, etc.) tend to be harder to predict, and therefore less appealing to banks.
They’re also keeping an eye on macroeconomic trends.
The Bottom Line
So to summarize, banks want to see:
- Years in business: At least 3 years, but typically more like 6-7 years
- History of profitability: At least 2 years of profitability
- Revenue: At least $1-2 million in annual revenue, but typically more like $3 million
- Capacity: Debt service coverage ratio of at least 1.15 is a must
- Credit: At least 680, but closer to 800 for “ideal” customers
- Collateral: Enough collateral to cover (almost) the entire the loan amount
- Industry: A known industry with a predictable and well-established business model
If you fit some or all those criteria, then you should definitely try to get a bank loan. If not, save yourself the trip (though a phone call typically won’t hurt!).