Loans 103: All About Other Loan Terminology

In our previous articles, we covered the primary costs of applying for and repaying a loan. While these cover the bulk of loan terms most borrowers evaluate, there are a few other common ones to remember when shopping for a loan. 

Some of these terms aren’t a “cost” per se; however, these costs can still significantly negatively impact your business. We’ll cover these terms and some other loan terminology in this article; read on to learn more.

The information discussed in this article is provided for informational purposes only and should not be relied upon as financial or legal advice. For financial or legal advice, you should consult a professional financial advisor or your attorney.

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Personal guarantee

What is a personal guarantee?

A personal guarantee is when a borrower essentially puts their personal assets on the line to secure a loan. A business loan with a personal guarantee allows the lender to legally go after the borrower’s personal assets in case the business defaults on their loan. 

Personal guarantees require a hard personal credit check and will impact the individual’s credit score. A “limited personal guarantee” caps the amount of the guarantee to a specific dollar value or percentage. In contrast, an “unlimited personal guarantee” has no cap and leaves the guarantor fully liable to repay the loan.

Why would a loan require a personal guarantee?

Personal guarantees are generally put in place when a business doesn’t have a strong enough — or long enough — track record to attain the loan on its own. In these cases, the risk posed to the lender is higher, and the lender needs a way to recoup repayment when a business fails to repay the loan.

For example:

• A small restaurant business with low sales and/or growth projections

• A new restaurant opening with a limited sales history or limited business track record

• A restaurant with poor business credit or little to no credit history

• A general business loan where the business has no significant collateral to secure the loan with

SBA Loans also require unlimited personal guarantees from any individual who owns 20% or more of a business.

Collateral

Certain loans are secured by collateral, which is an asset that can be used to repay a defaulted loan, whether wholly or partially. 

Lenders need to create a UCC (Universal Commercial Code) filing with the relevant Secretary of State for the borrower. The UCC filing establishes the lender’s right to seize that collateral in the event of a default. It allows other potential lenders to see what assets are already pledged by a borrower.

What is a secured loan?

Some type of collateral is needed to back a secured loan. Secured loans can have undesired consequences in the event of a default. For example, imagine you pledged your car as collateral for a restaurant loan you unfortunately defaulted on. If the lender takes your car as collateral, not only will you be inconvenienced by losing your vehicle, but your business could also be impacted if you can’t drive and purchase inventory.

A simple example of a secured loan would be financed equipment. Let’s say you financed a walk-in refrigerator with a secured loan. That loan is secured by the fridge as collateral, which would then be repossessed (“repoed”) if you were to default on the loan.

What is an unsecured loan?

An unsecured loan is not secured by any collateral. As you can imagine, unsecured loans are inherently riskier for lenders as they don’t allow lenders to offset or recoup losses through the possession of collateral. The higher risk lenders face generally leads to a higher bar for eligibility requirements and higher loan costs to make up for the unsecured nature of those loans. 

To help offset some of the risk of unsecured loans, lenders might require personal guarantees, which we covered at the top of this article.

What is a sales-based loan?

A sales-based loan (sometimes called sales-based financing) is a unique type of loan backed by the borrowing business’ sales. In essence, it’s a secured loan that’s secured by those sales, as opposed to a physical asset. Borrowers of a sales-based loan generally pledge a percentage of their sales to secure and repay that loan. Merchant cash advances are an example of a sales-based loan.

This type of loan is less risky for a lender than a fully unsecured loan but still carries risk when the borrower goes out of business, has a prolonged pause in sales, or otherwise closes down. As such, a sales-based loan sometimes still requires a personal guarantee to reduce the lender’s risk further.

Even though sales aren’t physical collateral, lenders still submit a UCC filing to claim a security interest in future sales-based receivables. This also allows lenders to establish their “position” (priority) to receive those collateral (in this case, sales) in cases where multiple lenders have rights to the same collateral.

Prepayment penalties

What is prepayment, and what is a prepayment penalty?

Prepayment, or early repayment, is when a borrower makes an off-schedule payment to repay the loan sooner than the target maturity or repayment term.

• Partial prepayment is when a borrower repays a chunk of their loan in advance but not the outstanding balance in full. For example, a borrower with an outstanding principal of $100,000 makes a one-time payment of $25,000 to reduce their outstanding principal to $75,000.

•  Full prepayment is when a borrower repays their entire outstanding loan balance. For example, a borrower with an outstanding principal of $100,000 makes a one-time payment of $100,000 to repay their loan fully.

For fixed fee-based loans, the fixed fee must be repaid in full for the loan to be considered paid in full.  

What is a prepayment penalty or early repayment penalty? 

Some lenders charge a prepayment penalty fee for borrowers who prepay their outstanding loan balance. Depending on the lender, this fee could be a percentage based on the outstanding loan’s principal amount or a fixed amount.

Why would a loan have a prepayment penalty?

For interest rate-based loans, the lender would lose out on all interest-based payments on the prepaid principal. These lenders generally charge a prepayment penalty fee to recoup this otherwise consistent revenue stream.

Deferral/deferment

What is a deferral/deferment?

A loan deferral, or loan deferment, is when a lender allows a borrower to temporarily reduce or pause the repayment of a loan they took out. It’s important to note that not every lender is willing to offer a loan deferment. They are usually not meant for permanent issues (such as a restaurant going out of business).

The SBA 7(a) loan program allows lenders to offer loan deferments for a stated period of time when a borrower experiences a temporary cash flow problem. However, a loan deferment is not an option for a permanent problem that could harm the borrower, lender, and/or SBA.

For example, let’s say a restaurant with an outstanding loan experiences damage from flooding; unfortunately, they can’t serve guests and need to shut down for a month for repairs. The restaurant contacted their lender, and luckily, they are willing to work with the restaurant through this hardship. The lender offers a 30-day loan deferment so payments can resume after repairs are completed.

Wrap-up

Congratulations — by now, you’ve covered the major terms and terminology of various types of business loans. You're now better equipped to evaluate different loan options by comparing terms and trade-offs to consider.