Refinancing your business loan can be an effective way to improve your cash flow, reduce risk or prepare for future growth. In the midst of a refinance, it may be easy to lose focus—and interest—in continuing with the process. Before getting started, you should consider taking these three steps.
1. Understand the reasons to refinance.
It can make sense to refinance your business loan under several scenarios:
- Your current loan has a high interest rate and current rates are lower; refinancing can save you money
- Your current loan payment is high and you want to refinance for a longer period of time to lower the payment; refinancing can buy you time
- Your current interest rate is variable and you want the security of knowing your interest rate won’t change; refinancing can buy you peace of mind
- The asset that you used to secure the loan has increased in value significantly and you want to refinance a larger principal balance; refinancing can give you more cash for immediate use
- You don’t have a good relationship with your current lender and you’d rather work with a financing partner that you feel is a better match for your business; refinancing can help you get out of a bad relationship.
While these aren’t the only reasons to refinance, these are the ones that may make the most sense.
2. Determine if the numbers make sense.
Before making the decision to refinance an existing business loan, you should conduct a cost versus benefit analysis. Refinancing a loan usually carries upfront fees that can range from 1 to 7 percent or more. The reduction in the interest rate—a benefit that you experience over the life of the loan—should be greater than the upfront fees you have to pay today in order to make the switch worthwhile.
It’s also important to take into account the amortization of the loan. Most loans have a fixed payment amount that consists of principal and interest. Even though the payment doesn’t change, the composition of the payment does change. At the beginning of the loan, much of your payment will go toward paying interest costs. But toward the end of the term, almost all the payment goes to pay off principal. As a result, the benefit from refinancing can be reduced the closer you are toward the end of the loan. A $1 million, 7-year loan at 5 percent annual interest will have monthly payments of $14,331.91. The first payment in month one will see 29 percent, nearly $4,200, go toward interest, while during the last year of the loan, interest will average just 3 percent of payments, or $375. At that point, it may be difficult to justify a refinance since doing so would mean you would once again be paying more interest out of each payment.
3. Get comfortable with the terms and conditions.
Things change. A new loan means new terms and covenants. The terms refer to the interest rate, fees, payment schedule, length of the loan and other related features. Loan covenants are promises you make on behalf of your business that certain conditions will be met and certain actions won’t be taken without permission from the lender. Covenants are negotiable, and you might take advantage of that fact.
Some covenants can be so onerous that they could make it difficult for you to run your business without violating one. These include:
- Minimum cash balance requirements
- Minimum ratio of cash to expenses
- Maximum debt to capital ratio
- Ban on taking on more debt without permission
- Prior approval for major equipment purchases
Violating a covenant may trigger different responses from the lender. Some are flexible and work with small-business owners to achieve an outcome that makes sense for both sides. Others will demand immediate repayment of the loan.
Read more articles about financing.
A version of this article was originally published on December 18, 2015.