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BUSINESS LOANS 

WHAT IS A BUSINESS LOAN?

Obviously enough, a business loan, is a loan taken out for business purposes. It is not a loan for private purposes. 

A business loan may be unsecured or secured. Under an unsecured loan, the lender's only right is to take action against the borrower to recover the debt. Under a secured loan, in addition to suing the borrower, the lender can take possession of and sell any property given the security. Property includes real estate (ie, land) and other kinds of assets (eg. motor vehicles, stock in trade, goodwill). 

WHAT IS A GUARANTOR?

Sometimes the lender will require a guarantor to guarantee that the borrower will pay the loan. A guarantor will usually be required by lenders where a loan is made to a company. For small private companies usually all the directors and shareholders will be required to guarantee.

The lender's rights against a guarantor may be unsecured or secured. Accordingly, the guarantor may or may not give security to support the guarantee. 

KEY ISSUES RELATING TO BUSINESS LOANS

  1. Quite often personal assets are charged to secure business loans. For example, Mr and Mrs Jones might mortgage their home to secure a loan made to a business run by Mr Jones or run by his company, X Pty Limited.
  2. The key element in deciding whether a loan is a business loan or a personal loan is the purpose to which the money is applied. Obviously, many loans could be partly business loans and partly personal loans. It is usually better to split these loans into two separate loans or at least two separate accounts. This keeps them separate for tax purposes. This is important because usually the interest fees and charges on business loans are tax deductible, whereas interest fees and charges on other loans are not tax deductible.
  3. Often, lenders will require guarantors to obtain independent legal advice and sometimes independent financial advice. This is because many guarantors of business loans have been able to escape their liabilities as guarantors on the basis that they did not understand what they were doing, or did not understand the financial consequences of what they were doing by giving the guarantee. If your lender asks you to get legal or financial advice, although this may be inconvenient and cost money, the lender is doing it to ensure you understand your rights and obligations properly.
  4. Simply because a loan is for business purposes does not mean that the interest fees and charges will be tax deductible. Usually, the test is whether the money is borrowed for the purposes of producing assessable income. This test will be satisfied for most but not all business loans. If in doubt obtain specialist tax advice. Obviously, it is important that the interest fees and charges are tax deductible if possible, because that significantly reduces the after tax cost (ie, the real cost to you).

COMMERCIAL CONSIDERATIONS WHEN NEGOTIATING BUSINESS LOANS

Interest rate

Interest rates are usually made up of 4 components, although these components may not be separately itemised in the way the rate is quoted.

Component 1 - The cost of money. Every business which lends money either has to borrow that money or use its own capital to make a loan. That borrowing or capital has a cost. For example, the cost of funds to most banks for a variable rate loan is an interest rate about equal to the bank bill rates as quoted in the newspapers.

Component 2 - A margin to cover costs for the lender. A lender will incur costs in making and administering the loan. Part of the interest rate will be applied to recoup these costs. 

Component 3 - Profit. A lender usually wishes to make a profit from making the loan.

Component 4 - Risk margin. The risk margin will vary dramatically depending on the lender's perception of the risk. For example, the margin applied to home loans or loans to big companies with undoubted creditworthiness is quite small. On the other hand, unsecured personal loans where there is a much higher risk of the lender making a loss will attract a higher profit margin. For example, the margin applied to personal loans and credit card loans is higher than the margin applied to home loans. 

Fees and charges

When comparing loans, it is important to take into account all fees, charges and other expenses (eg legal costs and stamp duty) associated with establishing and repaying the loan. These costs should be amortised (ie spread) over the proposed term of the loan, so that you can see the real cost of borrowing the money. 

Monthly interest is more expensive than quarterly interest

The "real" interest rate increases when the frequency for debiting interest is shorter. For example, 5% per annum with interest debited monthly is a higher interest rate than 5% per annum with interest debited quarterly. 

This is because where interest is debited monthly, the lender receives the interest more frequently and can use that money for other purposes. (By the way, this is important when comparing investment products where you are placing money on deposits with banks or other financiers. If they offer to pay you interest 5% per annum with interest payable every 6 months, that is not as good a deal as 5% per annum with interest paid every month). 

Principal and interest or interest only? 

An interest only loan is a loan where principal is not repaid during the term. For example, if you borrow $30,000 for 3 years at 7% per annum fixed, with payments of interest only being made each month, you will still owe $30,000 at the end of the term.

A principal and interest loan is often called an amortising loan. Under an amortising loan, regular payments of principal are made throughout the term. You need to check, however, whether the whole of the principal is repaid over the term. Under some amortising loans, at the end of the term there is a balloon payment due. For example, a loan of $300,000 over a term of five years with monthly payments of $3,000 per calendar month might have a balloon payment (ie a balance of the principal owing) of $200,000 at the end of five years. 

The decision whether to take an interest only loan or a principal and interest loan depends on many factors. Sometimes for tax purposes it is better to have an interest only loan, so long as you can use the borrowed money to make more money. On the other hand, if you are simply putting the spare money in the bank, it is usually better to pay the loan off. Cash flow considerations must also be taken into account when deciding what sort of loan to take out. Careful consideration must be given to ensuring that there will be adequate funds available to pay out regular payments as well as any balloon payments at the end of the term.

It is also relevant to look at the reason for taking out the loan. If possible the length of a loan should match the useful life of the asset or assets being financed.

Businesses can obtain the best of both worlds by obtaining a come and go loan, sometimes called a line of credit. Under these loans, the borrower has the option whether to reduce the principal, and can redraw at any time.

Most businesses should seek out loans which have the ability to redraw (ie borrow back some of the money repaid), to cover periods when cashflow is tight. 

A variable rate loan can either be set to an external reference rate (eg the bank bill rate), or be entirely variable at the lender's discretion. If the interest rate is entirely variable at the lender's discretion, you should ensure you are dealing with a reputable lender who will not arbitrarily increase interest rates to your detriment. Of course, under any variable rate loan, there is a risk that interest rates may increase significantly during the term and thereby change your financial obligations. To minimise or eliminate this risk, many businesses elect for a wholly or partly fixed rate loan.

It is very difficult to forecast how interest rates will change in the future. Many economists make forecasts, but they will not necessarily be correct, as interest rates are affected by so many factors. At the end of the day, the risk of variation in interest rates is just another risk of doing business.

Secured or unsecured?

As indicated in the general information above, loans can be secured or unsecured.

Security can be provided by the borrower or the guarantor or both.

Usually, lenders will apply a lower risk component to the interest rate where security is provided. This is because the lender's risk of loss is less when the lender holds security.

However, there are usually additional costs in putting a secured loan in place (eg documentation costs, legal costs). You should work out those costs and see whether they offset the lower interest rate derived from giving security.

Security

There are many different types of security. The most common forms of security are the following.

  1. Real estate mortgage.
  2. Bill of sale - This is a charge given by an individual over goods.
  3. Fixed and floating charge. This is sometimes called a debenture or an equitable mortgage. It is a charge given by a company over all or a specific portion of its assets.

HIRE PURCHASE AGREEMENTS AND LEASING

Businesses often arrange financing by acquiring equipment pursuant to leases or hire purchases.

A lease or hire purchase differs from a loan, because there is no borrowing or lending. Instead, the hirer is making rental payments to the financier. The financier retains ownership of the goods until all payments are made.

Leasing agreements

Leasing agreements may either be:

(a) finance leases;

(b) operating leases.

An operating lease generally arises when it is not intended that the hirer will end up owning the equipment. For example, if you hire a car from Avis for a month or so, this will be an operating lease.

Under a finance lease, there is an unwritten understanding under which the financier will sell you the goods at the end of the term for the residual value. Usually, the financier/lessor is entitled to depreciation on the equipment leased during the term of the lease. Often, therefore, the choice between hire purchase and finance leasing depends on the taxation profiles of the financier and the hirer.

Hire purchase and leasing can provide attractive alternatives to borrowing money for businesses. Accounting standards may still require the business to disclose the future liability under a finance lease or hire purchase agreement in the same way as the liability of the loan must be disclosed.

Usually, hire purchase agreements and finance leases are like fixed rate amortising loans. However, the effective interest rate may be a less than borrowing money because of the fierce competition that exists in the leasing market in Australia. 

FURTHER INFORMATION

This Information Outline is provided courtesy of McKean & Park Lawyers & Consultants who are experienced in this area of law. They are located at 405 Little Bourke Street MELBOURNE VIC 3000 or call them on (03) 9670 8822 if you would like more information on the legal topic, or you wish to obtain formal advice regarding your situation.

McKean & Park was established in 1863 by James McKean and thrives today with 20 professionals specifically in all major areas of practice including Workplace Relations and Anti-Discrimination Law. The firm is proud of the fact that many of its Lawyers are accredited specialists approved by the Law Institute of Victoria. McKean & Park is committed to providing clients with comprehensive and innovative legal services delivered promptly in a professional and cost effective way.

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