The Right Loan for The Right Reason

As a banker I frequently have people coming to my office asking for money; usually a line of credit. “I need a line of credit”, they tell me. “What are you planning to do with the money?” I ask. “I want to buy a new truck for my business”. After which I say, “You need a loan to buy a truck, not a line of credit”. The prospect looks at me surprised and then asks “What is the difference?” And I start to explain.

A line of credit is a pre-established amount of money extended to a borrower by a lender that the borrower can draw against as needed. There usually aren’t any rules that dictate how the borrower can or should use the line of credit; however, the line should never be used frivolously. The interest rate is tied to the amount of money borrowed, so in other words, you pay interest on the balance of the line. The minimum payment available is the interest only payment, meaning you are not decreasing the amount owing. If you pay in addition to the interest only payment this amount start paying down the principle and that amount becomes available to use again. With a line of credit, you have more flexibility in how much you repay each month. You can continue this spending and repayment cycle until the pre-negotiated term on the line of credit expires.

So what is the best purpose for a line of credit? A good use is to finance gaps in account receivables, seasonal sales operations, and certain kind of inventory (fast turnover) or to purchase something that is going to be repaying fast. All commercial lines of credit will expire at certain point and they have to be repaid in full (usually after one year). If for some reason the line can not be renewed and the business doesn’t have enough money to repay in full there is a problem. It is easy to think “I’m going to buy the truck I need and I will pay back the line with the sales of three months” Then sales don’t go as planned or we spend the money somewhere else, minimum payments (interest only) are paid and after three months there is more debt. The line of thinking is “I will start adding to the principal as soon as I have more income”. Guess what? We are always tempted by the minimum payment ghost and we never pay the extra principal borrowed. This starts a vicious circle, and in the end we will have a maxed out line of credit and a tramp of interest only payments.

A loan is an arrangement in which a lender gives money to a borrower, and the borrower agrees to repay the money, usually along with interest, at some future point(s) in time. Repayment is made in installments meaning that you’ll make equal monthly payments throughout the entire loan term. The term can be one, two, three or more years.
Because there are no minimum payments on a loan we don’t have an option to choose and we will be reducing the principal on the loan no matter what. Loans are good for real estate, vehicles, equipment, building improvements, business purchase or any purchase that is going to be repaying slow.

As you can see, lines of credit sometimes used for the wrong reasons and end up not benefiting the business owner. Communication with your banker is very important. If you don’t know something, ask questions. Your primary responsibility as a business owner is to protect and grow your business; nobody expects you to know everything about lending, leave that to the bankers. We are here to help, especially during this time with the economy the way it is. A cup of coffee and a good talk with your banker; what a great combination!

By Walter J. Acuña, MBA
AVP, Relationship Manager
PlazaBank
207 W. Kent Station St 101 - Kent, WA 98032
wacuna@plazabankwa.com
(253) 981-6345 W
(253) 249-6756 C
(253) 852-1442 F