A loan is a very simple thing when you get down to it. You get some money and you agree to pay it back with interest. It doesn't matter if your business is a success or a failure, all the risk is on your shoulders alone.
In business, we take it for granted that risk is just a part of life. When borrowing money for your business a lender may not lend you money if they think they are not going to be paid back. The risk of not getting paid back calls for the lender to ask for a bit of security like a mortgage on the business owners house, so if they don't keep up on the payments they can take and sell the house to cover the loan.
If you weigh the risk of borrowing the money to the risk of selling a part of your company to investors, the business owner would rather borrow the money and take the risk alone. The business man is confident that they will be a success and they do not want to share that success will investors.
The Promissory Note
When borrowing money you’re going to have to sign a paper that states you promise to pay back your loan plus interest. It also states how and when payments are to be made. This document is called a "promissory note".
Putting the loan in writing is a good idea whether you’re loaning the money to your brother in law or borrowing from a commercial lender. A handshake just doesn't cut it anymore.
Forms of Repayment
Lump sum repayment. You agree to pay principal and interest in one lump sum at the time agreed upon. Under this plan there would only be one payment for the loan and the agreement would be settled. This form of repayment can contribute to your business saving money and not having to worry about making monthly payments.
Periodic interest and lump sum repayment of principal. You agree, for example, to pay interest only for two years and then interest and principal at the end of the third year. With this type of loan plan, often called a "balloon" loan because of the big payment at the end.
Periodic payments of principal and interest. You agree, for example, to repay one-fourth of the principal each year for four years, plus interest at the end of each year.
Amortized payments. You agree, for example, to make equal monthly payments so that principal and interest are fully paid in five years. Under this plan, you'd consult an amortization table in a book, on computer software, or on the Internet to figure out how much must be paid each month for five years to fully pay off a loan plus the interest. The table would say you'd have to pay a fixed amount each month. Each of your payments would consist of both principal and interest. At the beginning of the repayment period, the interest portion of each payment would be large; at the end, it would be small.
Amortized payments with a balloon. You agree, for example, to make equal monthly payments based on a five-year amortization schedule, but to pay off the remaining principal at the end of the third year.
Prepayment penalties
When you borrow money, it’s possible to pay off the principal faster than called for in the promissory note, since this stops the accruing of interest. In other words, if you have a three-year loan but are able to pay it off by the end of year two, you don't want to pay interest for year three. By law, some states always allow such early repayment, and you pay interest only for the time you have the use of the borrowed money.
But in other states, the law allows a lender to charge a penalty (amounting to a portion of the future interest) when a borrower reduces the balance or pays back a loan sooner. It seems unfair to have to pay anything for the use of borrowed money except interest for the time the principal is actually in your hands. Make sure any promissory note you sign says you can prepay any or the entire principal without penalty.
Cosigners and guarantors
If you don’t have sufficient collateral for a loan, the lender can ask for other methods to guarantee that the loan will be prepaid. One is having someone cosign or guarantee the loan. That means the lender will have two people rather than one to collect from if you don't make your payments. Be sure to explain to whoever cosigns or guarantees the promissory note, that they are risking their personal assets if you don't repay it.
Some lender wants the spouse to cosign the promissory note. If your spouse signs, not only are your personal assets at risk, but also all assets that the two of you jointly own like a house or a bank account. Also, if your spouse has a job, his or her earnings will be subject to garnishment if the lender sues and gets a judgment against the two of you because the loan isn't repaid as promised.
