Businesses that took out debt a year ago or even 3 years ago may find themselves in a situation where the cash flow used for the loan or the purpose of the loan has changed. Many businesses find themselves in a situation where a refinance makes sense because they either want to reduce their loan payments to use cash flow for growth or they may want to increase the loan amount because their business is expanding. Businesses are dynamic, but a loan repayment is usually static due to the fixed term of the loan. A floating rate loan is the exception.
Before you refinance your business loan, there are three things you must consider:
- Is there a prepayment penalty on your current loan and have you factored in the cost to your refinance? This is especially important if you have a fixed rate conventional loan or an SBA loan. Many SBA loans will have prepayment penalties for payment in full on a refinance. Depending on the type of loan and the length of the amortization, they can range from 3-10% in the first year and will burn off to 0 over a time period ranging from 3-10 years. If it’s a large loan, like a commercial mortgage or business acquisition loan, then the prepayment penalty can be high. While it’s not technically a prepayment penalty, there are many fixed rate loans offerred through a derivatives product called an interest rate swap (you and the bank swap rates, you want fixed and the bank wants floating). If you cancel the swap early, the intermediary is entitled to a make whole payment either to you or the bank depending on where interest rates are relative to the swap rate when the deal was consummated.
- Are your loans cross collateralized? If you only have 1 loan with your bank then disregard this point. But if you have a line of credit and a second loan (building mortgage or equipment loan) then check the fine print of your loan agreement. If your loans are cross collateralized then it’s possible the bank will ask you to refinance both loans rather than just one. Sometimes there’s a collateral shortfall that the bank handles by doing this. Other times this is just put in the small print of your loan agreement to make it hard for you to change banks. Before you look at refinancing your loan make sure this language is not in your loan agreement or note.
- You can’t payoff an SBA loan with another SBA loan. Many business owners don’t know the SBA guidelines when it comes to loan amortizations. SBA loans are made on the most favorable terms for bank financing in the marketplace (10 years for working capital and business acquisition or 25 years for real estate). Therefore, the SBA won’t extend the term of a loan beyond it’s original amortization. While there may be 1-2 exceptions, you would be paying off your SBA loan with a conventional bank loan and the payments and interest rate could be higher. As an alternative, you could take out a second SBA loan (limit is around $5 million aggregate). However, you would be making 2 payments where you would prefer to make one and it be a lower amount.