Seven years after the start of the Great Recession, lenders are loosening requirements and lending to businesses both large and small. Loan approval rates at institutional lenders rose to all-time high of 63.1% in October 2016, the fourth consecutive month of improvements. The small business loan is getting easier to win because lenders find their yields irresistible.
In today’s economy, the Federal Funds rate stands at .75 percent, mortgages yield two to three percent and personal loans five to seven. It’s not surprising that the small business loan yield of 12% and up appeals to bankers and other lending institutions. Small business loans are one of the few places a bank can make a double-digit return.
These positive trends have prompted financial experts to predict that overall business debt will rise in the coming years . . . a lot. Where today, American businesses carry $51 trillion of outstanding business debt, S&P Global Ratings (formerly Standard & Poor’s Ratings) predicts that by 2020, this figure will surge to $75 trillion. Before you jump into using “other people’s money” to grow your business, consider your long-term goals as well as your best- and worst-case growth scenarios.
Should You Join the Small Business Loan Borrowing Frenzy?
Can small businesses trust this encouraging climate? Get clear on your comfort-level with small business borrowing before you fall for any “easy, fast!” commercial loan message.
When a business uses debt (rather than its own funds) to grow, it increases its return. A business needing a $10,000 investment can put in the capital from owner funds. After winning a gain that year of $2,000 on that $10,000, the business can state that it got a 20% return on that money. The $10,000 stays invested, untouchable.
On the other hand, if a business invests only $1,000 of its own money and borrows $9,000 and still makes $2,000 on that investment, it can say it made over 100% on its investment of $1,000. The business gets to keep most of the $2,000 profit after all. If the interest rate for the year is 10%, the business will have paid $900 in interest that year but earned, $1,100. The business still can get its initial $1,000 back plus the profit of $1,100 or $2,100.
When a business has orders beyond its current capacity to meet them, it must add labor and materials in order to meet the demand. The business needs the money up front. Having more demand than capacity is an ideal scenario for borrowing, much better than borrowing in order to merely stay afloat at current profit levels.
Is Easier Business Credit Good for the Economy?
Many Washington politicians, including President-Elect Donald Trump, are pushing for banks to have more leeway to lend. They argue that government regulation hampers business growth.
While easier business credit has fueled gross domestic products of many countries, it’s also gotten economies in trouble (see Greece and Spain, 2010).
The American housing crisis occurred because banks reassured borrowers that they could handle burdensome loan amounts, far more loan than they could afford. When homeowners defaulted on mortgages during the housing crisis, banks foreclosed on them. If commercial lenders start convincing borrowers that they can handle big business loans when they don’t have the orders coming in, borrowers could end up defaulting just as homeowners did. Banks will be within their rights to recover monies lent to businesses. Businesses can be lost via poor borrowing as easily as homes. Financial writers are calling this scenario, “Crexit” for an exit of credit.
The name “Crexit” derives from the British “Brexit” where citizens of the United Kingdom voted to leave the European Union. While not quite a perfect parallel, Crexit does refer to the exodus of commercial lenders from the market, forcing business owners to liquidate to pay off loans.
Your decision to take on a business loan depends on your outlook: will the economy remain relatively stable over the next five years or could there be another serious downturn?
The elements of a stable economy include:
- capital markets remaining strong to fuel business growth
- consistent GDP growth
- low interest rates (keep in mind that, even though the Federal Funds rate will be moving up slowly from its current .75%, this rate is still historically very low)
- freedom from surprise economic disruption
No one has a crystal ball and economic disruptions tend to strike at least somewhere in the world every few years (even if it’s far away, it still scares markets and people). Natural disasters and countries defaulting on debt seem to always be in the cards. Mild economic shake-ups are a natural part of an economy. Despite these blips, most economists believe we won’t see another recession as severe as 2009 through 2012 in the next five years.
The prospect that business lending will rise by 50% in the next 4 years is neither something to fear nor relish. If consumer spending grows steadily as it has over the past 4 years, an increase in business lending of this magnitude is nothing to be concerned about.
The Small Business Loan: A Personal Decision
One way to get clear on whether you should borrow or not is to sit down with your profit and loss history as well as income projections for the next 3, 6 and 12 months. Organize all loan costs in front of you, too. Work up three different potential revenue scenarios: conservative, surprisingly robust and an intermediate outlook. Your accountant can help. Could the conservative scenario lead to you losing the business? Does the middle-of-the-road possibility bring in enough profit to justify the costs from of a loan? Do you want to be part of the surge to $75 trillion or watch from the sidelines?