WHAT TO LOOK OUT FOR WHEN BORROWING

Whatever the source of funding you choose, the total amount available should not be your only criterion. The five key issues to consider in respect of any loan are as follows.

Price

By this I mean the cost of taking out the loan. This will generally comprise two elements: interest and charges, and when comparing financing packages it is important to take an overall view of both. You may, for example, find that a lender is being flexible on interest rates only to load other charges.

BUSINESS BORROWING ABILITY READY RECKONER

To calculate a business’s indicative borrowing ability, complete the form below using:

• the basis of valuation noted to calculate the security value of the assets; and
• the percentages shown to calculate the likely borrowings available.

Your actual borrowing ability will be determined by a number of factors and the table below can act as a general guide only.

One example of this was a bridging lender that was offering interest rates of 0.5% a month lower than the competition. What was not mentioned until you went through the small print of the offer was that they then charged an exit fee at the end of any loan which was the equivalent of 0.5% per month of the life of the loan!

Interest rates will often be quoted on the basis of a percentage over one of two figures so make sure that you know which rate is being used. The two rates are either:

• base rate which is the rate set by the Bank of England; or
• LIBOR (London Inter Bank Offered Rate) which tends to be slightly higher than base.

Rates quoted may be either of the following.

• Variable, in that the interest charge payable on the loan will move up and down in line with any movements in the underlying base rate.
• Fixed, in that the interest rate remains fixed for a specified period irrespective of any movement in base rates during this time. This has the advantage that the level of your payments is fixed for the period, which can help you in planning your finances. It also protects you from any increase in base rates. The disadvantages are that you will tend to pay a small premium in rate over current variable rates for the benefit of fixing. It also means that you will forgo the potential benefit of having a cheaper rate should interest rates go down. There are also usually penalties if you wish to terminate the loan early.

Variable rates may also be discounted for an initial period so that a reduced interest cost is borne in the early years.

For larger loans banks will offer clients the ability to hedge their risk, by for example purchasing a cap which acts as an insurance policy against movements in interest rates.

With a cap, a company is protected against the effect of increases in interest rates above the level of the cap in that in the example in Figure 9 10% is the maximum rate that the company will ever pay. Obviously the company will have to pay a premium for this policy, but this can be mitigated by taking out a matching floor (sometimes also known as a cap and collar, see Figure 9) where the company agrees a minimum interest rate that it will always pay. Then if rates go down the company will not get the full benefit because the lender will enjoy the difference between the floor (of 5% in the situation above) and the actual rate.

These techniques have in the past only been available to large corporate borrowers raising millions of pounds, but are increasingly becoming available to smaller businesses borrowing sums of, say, £250,000 and up.

Charges will include both arrangement fees for setting up the loan and ongoing charges that will arise through the life of the agreement, such as ongoing transaction based bank charges. It is important therefore to try to ensure you have a view of the likely total cost of the facilities over the period, so as to compare different facilities on a like for like basis.

While talking about charges, it is worth noting that UK banks are supposed to offer small business customers a choice between free banking or receiving interest on accounts in credit. It does appear, however, that banks do not push the free banking option very hard, so if you are paying bank charges it may be worth asking your bank manager whether these can be avoided.

In addition to the lender’s own charges there may be other costs to take into account such as:

• SFLG scheme premium if applicable;
• valuation costs, where a lender will require an independent valuation of assets to be taken as security which will need to be paid for.

Term

Term means the length of time you will have over which to repay the loan. This may range from say six months for a bridging loan, to five to ten years for a general purpose business term loan, through to 25 to 30 years for a commercial mortgage.

If you take out an overdraft your bank will provide you with a facility letter setting out the period that this facility will be in place. Remember, however, that an overdraft is always repayable on demand, so while a facility letter gives you some comfort that the facilities will be available for the specified period, this is not a guarantee.

Security and conditions

First consider what security the lender is requiring for the loan, specific fixed or general floating charges, or both? Are they asking for a personal guarantee? Can you obtain the same borrowings from another source while giving away less of your available security, so keeping more in reserve for future borrowings if required?

Secondly, it will cover any conditions that the lender attaches to the loan, known as covenants. For example, if you take out a mortgage in order to buy a commercial property to let to your business, the lender may attach covenants to the loan that you have to supply the lender with copies of the business’s annual accounts and that these must show the business:

• making a profit; and
• having a positive balance sheet.

For a trading business loan the covenants might cover provision of monthly management accounts, targeted levels of profitability and liquidity ratios to be maintained.

If you then breach these covenants you are in default on your agreement and this then gives the lender the right to exercise their security if they wish to. Of course in most circumstances the lender will not do so, but these act as both part of their early warning system for spotting problems and to clear the decks for action if required by giving the lender the right to take action.

Thirdly, the lender may also insist that you take out insurance cover such as a key man policy, which would pay out in the event of your death or serious illness, and that you note their interest on the policy so that it will pay out to them to cover the debt due.

As already discussed, your bank manager will be keen to sell this type of insurance (as one once said to me when discussing lending: ‘Remember, no banker ever lost money selling insurance’) so they will want to sell you the bank’s own tied policy. You should be able to shop around, however, and may well find a cheaper rate elsewhere.

Flexibility

One of the great advantages of term loans can be their certainty, in that you know you have a specific payment to make each month or quarter comprising a mix of capital and interest. But this certainty comes with a disadvantage, in that you normally have to make that payment each month or quarter, whatever your circumstances.

If you do run into difficulties there is nothing to stop you approaching your lender to explore whether the loan can be varied, for example by:

• being rescheduled to be repaid over a longer period so that the regular payments are reduced;
• switching to a period of interest only payments;
• or even by having a complete repayment holiday for a short period.

Some lenders, particularly in the secondary or tertiary markets where the lenders know that they will be dealing with borrowers who may require greater flexibility in their arrangements, will already have built some of these options into their products. So it is worth examining how much flexibility will already be built into your loan.

On the other hand, you may want to arrange to repay some or all of your loan earlier than scheduled, or terminate the arrangement so as to move to a different lender.

In this case you need to know the following.

• What early repayment penalties exist and how long will these apply? Penalties will generally apply to the initial period of most fixed rate or discounted rate loans as the lender needs you to remain as a borrower for a set period in order to either match the fixing of their own funds that they have had to do to provide you with the facility, or to make enough return at full rates of interest to compensate them for the initial discount. For example a typical repayment penalty regime on a second tier commercial mortgage provider might be a 5% penalty in the first year, reducing by 1% a year.
• What notice you will need to give? Typically on a factoring arrangement for example, you will be required to give a minimum of three months’ notice to the lender, although factors will sometimes try to negotiate such terminations between themselves, and the existing factor will agree to waive notice for payment of a penalty (which the new factor may help provide the company with some assistance to pay).

Are there any other constraints which will affect your ability to change? For example most factoring agreements are for a minimum contractual period of a year, during which time you cannot give notice, and some even specify that notice can only be given on the anniversary of the arrangement.

Cash impact

This is where you need to compare the actual cash movements that the funding will provide.

• Cash in: are you going to receive the whole of the agreed amount or will you only receive it net of the costs of arranging the loan, or even in the case of some bridging loans, net of the interest charges for the whole of the loan period which some lenders will deduct up front; and
• Cash out: where you need to be sure that the loan is affordable and where the actual cash being paid out by your business on its monthly or quarterly payments on a loan of the same amount at the same interest rate can differ widely as a result of:
  • the length of term taken, so for example a normal capital repayment loan of £100,000 at 10% interest would cost £1,322 per month over ten years, but over 15 years the monthly cash out at the same interest rate would be £1,075, a cash saving of £247 per month. The loan repayment table included at the end of the book sets out the monthly instalments you will pay on loans of five to 25 years in length at interest rates of 6% to 20%, which can allow you to see how much you can reduce your cash outgoings by increasing the period of the loan;
  • initial discounted periods, as discussed above;
  • interest only periods, where for example some commercial mortgage funders will now allow you to make payments of interest only over the first three years so that you do not have to make any payment in respect of the capital element;
  • or even no ongoing payments at all, as on some bridging loans it is possible, for example, to roll up all payments of both capital and interest until the end of the loan.

As a general rule, whenever considering affordability it is best to build in affordability and flexibility for yourself by borrowing long but paying short. This means arranging your borrowing over a longer period than you think you require (say 15 years when you think you can afford to pay back over ten), so as to reduce the regular payments that you are committed to, as in the example above. This means that if times get harder, you are not held to the higher level of payments that you thought you could afford to make, and when times are good, you can make higher payments and aim to clear the loan in the ten years you really envisaged, if not earlier. Obviously when using this strategy you need to check the repayment penalty position very carefully so as not to get caught out.

MONEY LAUNDERING

Most professional advisers and all lenders are now caught by the laws covering money laundering and the tracing of the proceeds of crime. These rules will introduce a degree of bureaucracy into any financial transaction you undertake.

The two main requirements that all such professionals and institutions need to adhere to and which will affect you are as follows.

Identify their clients

They will need to see original documents as evidence of your identity and address. They will therefore look to take copies of one form of identity for each of the following categories:

• Category A – identity, can be your passport or a photocard type driving licence;
• Category B – address, can be a personally addressed utility bill from within the last three months (but not a mobile phone bill), a bank statement or HM Revenue & Customs correspondence.

Shop their clients

They are now under a duty to report any suspicions they may have of money laundering, or that funds are the proceeds of crime, under which the government includes any evidence that might suggest tax avoidance. Such professionals face long prison sentences if they do not report anything that comes to their attention and can also be jailed if they tip you off that they have made such a report. So if you operate a cash business and your financial position would suggest to your advisers that you may have been working cash in hand to avoid VAT or tax, you need to be aware that they are now under a duty to file a report.

Other paperwork

There may be further paperwork that you will need to deal with in respect of raising funds depending on these factors.

• The type of funds you are raising: for example now that some mortgages are regulated, advisers will have to comply with the Financial Services Authority’s requirements to know your client. This means that they will need to complete a fact find on your personal financial circumstances in order to be able to advise you.
• The type of advisers with which you are dealing: for example, if you need to instruct an accountant to help you, they will be governed by their institute’s rules. This means that they will have to issue you with a formal letter of engagement setting out the terms on which they will act for you.