Loan Terminology: 8 Jargon Busters You Need to Know

The world of small business financing can be a confusing one—especially if you’re just entering it for the first time.

This industry has many acronyms and confusing loan terminology, and if you’ve never shopped for small business loans before, you might feel totally in the dark.

Whether you’re just shopping your options, comparing different loan offers, or signing an agreement, it’s important to know the loan terminology that relates to your financing.

We’re here to clear up some especially confusing loan terminologies so you can be fully equipped to find the right financing for your business.

DSCR

DSCR stands for Debt-Service Coverage Ratio—and is sometimes referred to as the Debt Coverage Ratio.

This financial ratio shows the cash a business has available to service its debt.

Essentially, debt service coverage ratio shows whether or not a business (on average) has enough cash on hand to cover a loan’s principal, interest, and leases.

To calculate DSCR, you divide your business’s cash flow (typically your net operating income) by the debt service payments (loan and lease payments).

The number that equation spits out can range from less than 1, 1, or more that 1.

Why You Should Pay Attention to This Loan Terminology

How does this relate to your business and affect your financing options?

Well, DSCR is an important indicator of your business’s financial health. It’s also something that a lender will look at to determine whether lending to your business is a smart idea.

It’s a measure of how comfortably your business can pay off debts. And if your DSCR comes it at a 1 or below, that’s a sign that you either you have just enough cash on hand to pay off your loan (but none left over for your business’s other needs), or you don’t have enough cash on hand to make your loan payments.

A DSCR of 1.3 or higher, on the other hand, will show a lender that you do have the cash to comfortably make each loan payment. This is a good sign that a lender will get its money back—making your business a smart investment.

The DSCR you need for loan approval will vary from lender to lender, and across different types of business loans. However, if you can show that you’re at 1.3 or higher, you should be in good shape.

EBITDA

Next on the list of confusing loan terminology is another acronym, EBITDA.

EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortization. Generally, it’s a measure of a company’s operating performance.

It’s a way to evaluate a company’s performance without factoring in tax environments, financing obligations, or accounting decisions.

This loan terminology comes into play when looking at a business’s profitability. It’s a different way to look at performance as compared to annual revenue, net income, net operating income, cash flow, and so on.

To calculate EBITDA, start by calculating EBIT. Your EBIT is Earnings Before Interest and Tax.

EBIT is the same as operating income. It factors in costs like the cost of goods sold, rent, utilities, and depreciation, subtracting these costs from your revenue.

You can calculate EBIT in one of two ways:

You can take your net income figure (found on your income statement) and add back in interest and taxes (net income + interest + taxes).

Or, you can subtract operating expenses from revenue (revenue – operating expenses).

Once you have your EBIT, add back in depreciation and amortization to get the “DA” part of the acronym:

Net income + interest + taxes + depreciation + amortization

or

Revenue – operating expenses + depreciation + amortization

Why You Should Pay Attention to This Loan Terminology

When it comes to this piece of lending terminology, you probably want to pay attention to your EBITDA coverage ratio.

The EBITDA coverage ratio compares your EBITDA to your company’s liabilities—like your debt and lease payments. This will help show whether or not you can afford to take on debt given the current state of your profitability.

Again, if the ratio is 1, then you’ll be able to pay off your debts, but just barely.

The average is a ratio of around 2, but higher is better: a higher ratio means that you have more money and less debt.

LTV Ratio

Another ratio to keep on your radar is the LTV ratio.

Spelled out, this is the Loan-to-Value Ratio.

The LTV ratio is a measure of financial risk—comparing the loan amount to the value of the asset that the loan is being used to acquire; in other words, it is calculated by dividing the loan amount by the value of the asset.

When you divide the loan amount by the asset’s value, you’ll get a percentage.

When borrowers request a loan for an amount that is the same or close to the value of the asset—and therefore a higher loan-to-value ratio—lenders perceive that there is a greater chance of the loan going into default because the borrower has very little equity in the purchase. Essentially, the borrower is financing the majority of the purchase through debt.

Why You Should Pay Attention to This Loan Terminology

While the most obvious and common use case for the LTV ratio is in mortgage underwriting, LTV ratios can come into play anytime you’re taking out a business loan to purchase an asset—like a piece of property or a piece of equipment.

When you’re applying to a loan for an asset acquisition, you’ll want to show that you have a lower LTV ratio.

Lower LTV ratios are lower risk for lenders because the borrowers have a larger amount of equity committed to the asset. Moreover, low LTV ratios can be leveraged by business owners with poor credit history to get financing—the lower ratio offsets the financial risk created by the business owner’s credit history.

Second Position

Let’s take a break from the acronyms and cover another confusing type of loan terminology—”second position.”

What does it mean to be in second position?

Well, this term relates to the lender you’re working with.

A lender is in second position when they’re lending to a borrower that already has business debt on their books.

So, if you have a business line of credit out for your business, and you go to apply for a short-term loan on top of that, the potential lender offering the short-term loan would be in second position to your current line of credit lender.

Why You Should Pay Attention to This Loan Terminology

While the loan terminology, “second position,” applies to small business lenders, it has implications on whether or not a borrower can be approved for a loan.

Oftentimes, a lender won’t work with a borrower if they’re going to be in second position to an existing lender the borrower is working with.

That’s because, in the worst case you can’t afford to pay back your financing, the lender in first position has right to recoup their losses first. So the first position lender could seize some of your personal or business assets and come away not too hurt by the default, whereas the second position lender wouldn’t have much to take from to recoup their losses.

Some lenders will take second position in any case or won’t be in second position at all, but some lenders might only take second position to a bank lender.

Blanket Lien

Another important type of loan terminology is “blanket lien” (and other types of liens, for that matter).

A blanket lien is a specific type of lien—and we’ll get into what that means for your business.

But a lien in general is a legal claim written into the fine print of small business loans.

They help protect lenders by providing some security in the event a borrower defaults and can’t repay them. When lenders file liens for unpaid debts, they are able to sell a business’s assets in order to collect money. This gives the lender some protection against risk when lending to small businesses.

Why You Should Pay Attention to This Loan Terminology

It’s important to note what kind of lien a lender is putting on your business—they come with varying seriousness.

A blanket lien, for instance, gives a lender the right to seize almost every kind of asset and collateral the borrower owns in order to pay off the debt if you can’t make your loan repayments.

If you’re a strong borrower, you probably don’t need to worry about having a blanket lien on your business—you can be confident that you’ll pay off your debts with your business’s earnings, and your business’s assets will come away unscathed.

However, if there’s reason to believe that you’ll struggle to pay off your business loan, then a blanket lien can be very dangerous. You could stand to lose a lot for your business if you can’t pay your debts.

Bridge Loan

A bridge loan isn’t any different that a normal type of business loan—at least in how it functions.

But the reason why it’s called a bridge loan—and how it can help a business—is what business owner needs to know.

A bridge loan is typically a short-term loan that a borrower can use while waiting for approval for another type of business funding—typically of larger amounts, lower interest rates, and longer times to funding.

A bridge loan “bridges” the gap between a borrower’s financing options.

Why You Should Pay Attention to This Loan Terminology

A bridge loan can be a valuable tool for a small business owner—so it’s important to keep on your radar.

A bridge loan can help you stay afloat as you raise rounds of venture capital, or it could help you finance a business as you’re waiting for approval from a bank or SBA lender. Those desirable types of financing take longer to approve, so you might want to use a bridge loan to cover the waiting period.

APR

When it comes to loan terminology that you need to know, APR is probably the most important.

APR stands for Annual Percentage Rate.

As it relates to small business lending, APR is the annual rate charged for borrowing funds. (In other contexts, APR can be the annual rate that’s earned through an investment.)

An APR is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan.

Why You Should Pay Attention to This Loan Terminology

The APR on a business loan should be the end-all-be-all way to determine if a loan is affordable.

That’s because it represents the true cost of borrowing.

While an interest rate might look similar to an APR, an interest rate doesn’t show the true cost of a loan.

APR includes not only what you’ll pay in interest, but also any fees you’ll have to pay when you take out financing. These could be origination fees, closing fees, application fees, etc.

In the end, APR can help you compare different loan offers—and what they’ll cost you—apples to apples.

Factor Rate

A factor rate is a piece of loan terminology that you might come across when applying to short-term loans or merchant cash advances.

It’s a way that a lender can quote the price of the loan—but it’s different from an interest rate or an APR.

A factor rate is expressed not in percentages—the way interest rates are—but as a decimal figure. They typically range from about 1.1 to 1.5, showing how much you’ll be paying back on your loan.

To understand a factor rate, you should determine the total amount you will need to pay back.

You can do this by multiplying the factor rate by the amount borrowed.

When a factor rate is involved, all of the interest is charged to the principal when the loan or advance is originated. That’s the key difference you need to know about factor rates and interest rates.

Why You Should Pay Attention to This Loan Terminology

A factor rate is important to keep an eye out for. You need to take steps to convert your factor rate into APR—otherwise your financing might seem more affordable than it really is.

Let’s look at a factor rate in action to illustrate this.

Say you’re getting an advance of $10,000 at a factor rate of 1.35 for a 12-month term.

Multiplying $10,000 by 1.35, the total amount you’ll need to repay is $13,500. Knowing you’re paying $3,500 for that $10,000, at first glance, you may think you’re simply paying a 35% interest rate for the advance.

But that’s not the correct way to think about factor rates.

Yes, the interest cost of the advance is 35%, but remember: when a factor rate is involved, all of the interest is charged to the principal when the loan or advance is originated. This is why the advance or loan isn’t priced using APR—APR is used for financing where interest accrues on the principal amount as it gets smaller and smaller as more payments are made.

When you convert a factor rate into APR, you’ll find that the APR is much higher than a factor rate would look at first glance.

Keep An Eye Out for Confusing Loan Terminology

This list of loan terminologies just scrapes the surface of all the different loan jargon out there.

When you’re shopping for a business loan, you could come across many more terms not included in this list. Hopefully, these definitions help you start out on the right foot.

When you come across a term you don’t understand during your loan process, it’s crucial that you take time to dig into what it means and how it affects your business financing. Run a quick internet search, talk to a financial advisor, or consult your accountant.

It always pays off to be in the know and read the fine print!

The post Loan Terminology: 8 Jargon Busters You Need to Know appeared first on Fundera Ledger.

from Fundera Ledger https://www.fundera.com/blog/loan-terminology
Loan Terminology: 8 Jargon Busters You Need to Know

first seen on http://barbarapjohnson.blogspot.com

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About mojafarma

Know how to a get business line of credit and promote online. Then come and read our blog. It’s a great resource for business related topics.
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