Five Questions to Ask Before You Sign Any Business Loan

Most business owners read a loan agreement once, in the week it needs signing, with a banker waiting on a decision and a deadline already set. The headline rate gets read closely. The pages after it get skimmed at best, even though they cover what the guarantee actually reaches, what trips a default and what happens if the loan changes hands.

That is not a failure of diligence. Loan documents are written by lawyers for lawyers, and the terms that end up mattering most are rarely on the first page. The good news is that the questions worth asking are few, specific and answerable in one conversation with the lender before anything is signed. Here are five of them, and why each is worth the slightly awkward moment of asking.

Why the interest rate is not the real decision

Lenders compete hardest on the number that is easiest to compare. The clauses that decide whether a loan helps your business or quietly constrains it for years sit in the definitions and covenant sections, the parts nobody reads aloud in the sales meeting. Those clauses tend to matter at the worst possible time, when the business is already under pressure and the terms stop being theoretical.

1. What does the personal guarantee actually cover

Almost every loan to a privately owned business carries a personal guarantee. For SBA 7(a) loans, every owner of 20% or more of the business is generally required to guarantee the loan personally, and the SBA can ask others to guarantee in some situations.

The details vary widely. An unlimited guarantee can reach your personal assets with no cap. If your spouse also signs, it can reach jointly held assets too. A limited guarantee caps your exposure at a fixed dollar amount or a percentage of the balance. Some guarantees are written to cover all present and future debts you owe that lender, not just this loan, which can tie your personal assets to borrowing you have not taken out yet.

Ask whether the guarantee is limited or unlimited and whether your spouse needs to sign. Ask whether it covers only this loan or all obligations to the lender. And ask whether it releases automatically when the loan is repaid or needs a separate release document. A guarantee that quietly outlives the loan it was written for is a common surprise, usually discovered while refinancing something else.

2. What will it cost to pay this loan off early

A loan that looks inexpensive can become costly the moment you want out early, because cash flow improved, you are refinancing or you are selling the business. Prepayment costs take several forms. Some are a flat percentage of the remaining balance. Some are a step-down schedule that shrinks over time. Others use yield maintenance, which compensates the lender for interest it would have earned.

SBA 7(a) loans are a useful reference point. On loans with a maturity of 15 years or more, prepaying 25% or more of the balance in the first three years triggers a fee of 5% in year one, 3% in year two and 1% in year three. Conventional commercial loans have no single standard, which is exactly why you need the specific calculation.

Ask for the exact cost of paying the loan off in full at the end of year one, year three and year five, in dollars and in writing. "The penalty is small" is not a number. On a $1 million balance, a flat 2% is $20,000. A yield maintenance clause in a falling rate environment can cost several times that.

3. What triggers a covenant default

Financial covenants are tested on a schedule, often quarterly or annually, against your actual financial statements. A default does not require a missed payment. It can be triggered by the numbers moving the wrong way while every payment has been made on time.

Here is an illustration. Say your loan requires a debt service coverage ratio of at least 1.25, meaning cash flow available for debt service must be at least 1.25 times your annual loan payments. Your business generates $500,000 of qualifying cash flow and pays $380,000 a year across its loans, a ratio of about 1.32. You are compliant. Then a slower year drops cash flow to $460,000. Your ratio falls to about 1.21 and you are in technical default, even though you have never been late.

Ask which covenants apply and exactly how each is defined. Ask how often they are tested and what the lender's usual practice is when one is breached. Many lenders will waive a technical breach for a fee or a conversation. That is a relationship habit, not a contractual right, and it is worth knowing which one you are relying on.

4. What is the true cost, all in

A headline rate and the true annual cost can diverge significantly once origination fees, packaging fees, document fees, required insurance and reserve accounts are added. Some short-term products, including merchant cash advances and some online lenders, quote a factor rate instead of an interest rate. A factor rate is not comparable to an interest rate without converting it.

An illustration shows why. A $100,000 advance with a 1.3 factor rate means you repay $130,000. If it is repaid in daily or weekly installments over six months, you only had the full $100,000 for the first few days. On average you held about half of it for half a year. Annualized, that $30,000 cost works out to a rate well above 100%, not the 30% the factor rate seems to suggest.

Ask the lender for the all-in annual percentage rate including every fee, plus a full repayment schedule in dollars. Then compare loans on total dollars paid and the timing of those payments.

5. What happens if the loan is sold

Lenders sell and assign loans regularly, and most agreements allow it without your consent. The written economic terms generally do not change because the loan was sold. Your point of contact can change, though, and so can the payment process and the new holder's appetite for flexibility on covenants or renewals.

Ask whether the loan can be sold or assigned, whether you will be notified, and whether servicing will stay with your current lender. Anything you are relying on should be in the signed documents. An informal understanding with a loan officer is worth little once the loan belongs to someone who has never met you.

Before you sign

A lender's sales team answers questions about the product. Its credit and legal teams answer questions about the contract. If a question about the guarantee, prepayment or covenants gets a vague answer from the first group, ask for it from the second, in writing. Then have your attorney review the documents and your accountant run the covenants against your own forecast. A covenant you would have breached in your last slow year is one you are likely to breach again.

Frequently asked questions

Do all business loans require a personal guarantee?

Most loans to privately owned businesses do, particularly where the business does not have credit history independent of its owners. SBA 7(a) loans require guarantees from owners of 20% or more. Some larger, well-collateralized facilities can negotiate limited guarantees, but it is worth asking rather than assuming.

Is a lower rate always the better deal?

Not necessarily. A lower rate attached to a steep prepayment cost, an unlimited guarantee and tight covenants can cost more over the life of the loan than a slightly higher rate with cleaner terms. Compare all five questions together.

Can a lender change my terms after selling the loan?

Generally the written terms stay the same, because they are set by the signed agreement. What can change is everything around it: the servicer, the payment process and any informal flexibility you had with the original lender.

How Kelly+Partners can help

Our Advisors help Private Business Owners look past the headline rate, from modeling covenants against your forecast to comparing the true cost of competing offers and planning how new debt fits your cash flow. Bring us the term sheet before you sign and we will help you know exactly what you are agreeing to. Book a discovery meeting.

This article is general information only and is not tax, legal or financial advice for your situation. Speak with a Kelly+Partners Advisor before acting on it.