Loans: A Quick Guide
This page can help you think about the type of loan that would be most suitable for you, or whether you should consider an alternative methods of raising finance, such as factoring (converting your invoices to cash as soon as they are issued).
Your options for obtaining loans or other forms of finance revolve primarily around the following questions:
- How much risk do you want to take?
- How much long-term commitment are you prepared to make?
- What are your cash flow needs?
- How much time are you prepared to spend in financial planning and making your case to someone else?
- Who do you want to go and see?
Generally, the more of the risk you are prepared to bear, the greater commitment you make and the more time you spend in financial planning, then the easier it will be to find suitable loans and the cheaper those loans will be. Factoring can be a good, easy-to-arrange and low-cost alternative for a business, though the amount of cash you can get is limited by the value of the invoices you issue.
How much risk do you want to take?
One choice here is between secured and unsecured loans. For secured loans, you take more risk in order to get a lower APR (interest rate). You provide an asset (eg: your house) as a guarantee, but if you fail to keep up repayments, the lender can take possession of and sell your house to get their money back. The amount of money you can borrow on secured loans is usually limited by the value of the assets you have to secure those loans with (eg: the value of your house).
For unsecured loans you don't provide any guarantee, so there is more risk for the lender and less for you - but you still have some risk because you have to pay the loan back, and lenders can still take some action against you to recover their money. The amount of money you can borrow on unsecured loans is usually limited by your ability to repay (eg: the difference between your regular income and your regular outgoings).
In a factoring agreement, you give your invoices to a factoring company and they give you instant cash in return, so there is no guarantee nor do you put any asset at risk. In fact, you reduce your risk of cash flow problems due to late payment by the customer. The improvement in your cash flow can have a similar effect to a loan. The amount of money you gain is limited by the value of the invoices you issue, but the longer your customers normally take to pay, the greater the effective cash benefit to you.
Another choice, one that you may already have made, is whether your business is a limited company or partnership/sole trader. A limited liability company 'does what it says on the tin': it limits your liability (ie risk), though there are some directors' liabilities that you need to consider.
Another choice to minimise risk is between fixed-rate, variable-rate or capped loans. Fixed rate loans mean that you pay the same interest rate no matter what the general market rates are. The payments for variable rate loans can go up and down with the general market interest rates. Payments for capped loans vary with the market, but are guaranteed not to rise above a certain level.
Note: the term 'tracker' is often used to describe loans or mortgages. A tracker mortgage is one that varies by tracking a particular rate, such as the Bank of England Base Rate (plus a percentage). In essence, tracker loans are variable-rate loans.
How much long term commitment do you want to make?
The main choice here is between fixed or flexible loans. This is nothing to do with the rate of interest but describes the terms of the payment schedule: whether you have flexibility to overpay the loan to eventually settle it early. If you make a long term commitment then you lose flexibility and may be stuck with the loan for a long time, or may have to pay significant financial penalties if you decide to pay it off early.
With factoring there is no commitment to ongoing payments - you simply hand over your invoices to the factoring company as soon as they are issued, and you receive an immediate cash payment for them.
What are your cash flow needs?
If you are stretching yourself, by taking the maximum mortgage available to you or by starting a business that requires a big investment, then there are various 'tweaks' that can be made to loans to help ease the pain of repayment in the early months or years. Common options are discounted loans, cashback schemes or payment holidays.
Discounted loans mean that the repayments are discounted for an initial period (this usually applies to a variable loan). A cashback scheme provides a similar discount, but gives you all the discount in the form of an initial extra cash payment to you. Payment holidays allow you, after an initial period of regular payment, to skip a limited number of monthly payments and add those payments to the loan.
The main advantage of factoring is that it removes cash flow problems due to the payment terms of customers or late payment. You get paid, by the factoring company, immediately the invoice is issued. Factoring can also complement other loans by helping you to reduce the size of the loan you need, and thereby reduce your costs.
How much time are you prepared to spend in financial planning and making your case to someone else?
There are various options available in response to this question, ranging from venture-capital through self-certification or bad credit loans. Venture capital involves obtaining funds from an individual or organisation looking to invest surplus funds in a new business. Venture capitalists don't charge you interest, but they do share the business risk and take a percentage of the shares in your company. They therefore require you to do a lot of work in preparing a business case so that they can be confident in their return on investment.
At the other extreme, self-certification is a means for people who cannot prove a reliable income to obtain a mortgage. Finance companies offer bad credit loans when they are willing to take a risk in order to get a higher return. Self-certification and bad-credit loans are usually very expensive.
There is not so much work required in obtaining a factoring agreement, as there is generally much less risk for the factoring company. However, they will need to be confident that your invoices are genuine and that the clients will pay (eventually).
Who do you want to go and see?
Whether you are looking for a mortgage or a loan, a key question when you go and see someone is whether they are independent or tied. Someone who is independent is usually paid by commission or a fee, but can advise you on the range of loans or mortgages available. Someone who is tied can only sell the products of one particular company; there may be a better product elsewhere that suits you better, though there can be genuine reasons for taking advice from a tied agent (eg: you have an established relationship with a bank manager who can take account of your track record and business judgement).
In general, only personal loans can be arranged remotely (by telephone or online). However, for businesses factoring agreements can be arranged remotely.
Loans and factoring agreements are not the only option for raising finance: you could obtain money through venture capital (already mentioned above), overdrafts, credit cards, hire purchase, endowments, personal contract plans, contract hire, rental, lease, shop/trade interest-free schemes and many others. You can also considering restructuring your finance (replacing existing loans with other loans on different repayment terms) or alternatives such as credit clubs.