With interest rates being cut substantially early in 2020 to assist the economy with the global pandemic, interest rates are at or near an all-time low. If you are expanding your business, there is an opportunity to lock down your financing at ultra low rates and control one of your larger operating costs. Below are some different programs and ways to finance such an expansion.
With these concerns in mind, what are my financing options?
Looking at fixed-rate loans to mitigate your interest rate risk takes some understanding of where you are in your business life. There are a variety of good programs that make sense to use, including conventional, SBA, USDA, Interest Rate Swaps, local revolving loan funds, and Industrial Revenue Bonds. Generally, there isn’t a perfect answer to what’s best, or an “only” option for financing your business expansion. However, some structures provide more flexibility than others:
- Conventional loans are the simplest to use. You’ll usually be able to get up to a 5-year fixed rate for real estate and equipment loans. These loans are required to be repaid over 5 to 7 years for new production equipment, or up to 20 years for real estate. Most banks impose a prepayment penalty if you refinance early, but allow you to prepay the debt with excess cash flow generated without penalty.
- Government guaranty loans (SBA 7(a), 504 and USDA) allow you to obtain a long-term fixed rate (up to 25 years for loan primarily secured by real estate from SBA and 30 years from USDA). The SBA 7(a) and USDA programs allow the borrower to combine the use of proceeds (equipment, working capital and real estate) into one loan if desired. The USDA has higher loan caps: up to $25MM versus $5MM for the SBA 7(a). The USDA is for borrowers who are located in rural communities. Both programs do have upfront costs with a sliding scale and are likely best used when expecting to have the financing structure in place for a long time (10 plus years). Otherwise, you pay for the upfront fees and don’t get the long-term benefit. Both programs offer fixed vs. variable rate loans. Given the current interest rate environment, I believe you may want a fixed rate to have payment and cost certainty. Some banks will only offer these loans if done via the variable rate. At Investors Community Bank, we generally offer clients the long-term fixed rate, as it removes their interest rate risk. The SBA 504 program is for fixed asset financing (equipment and real estate). These loans can be done for purchases and refinances for terms of 10, 20 and 25 years. At present, these rates are at or around the lowest they have been in the history of the program. An additional benefit is that some of the government guaranteed loan programs can be assumable. This can be a huge benefit if you sell the company or the real estate in a higher interest rate environment.
All of these government guaranty programs can aid borrowers who want long-term fixed rates, help with minimizing a required down payment (as little as 10% for some of the projects) and basically limit default risk to making your loan payments. I most often use these programs for major expansions or fast growing companies that have limited equity and strong forecasted earnings.
- Interest rate swaps are for more sophisticated borrowers who are looking for longer-term fixed rates. To utilize a swap, you’re entering a trade and converting a variable rate loan from your bank to a fixed rate loan to you. There’s risk in this type of loan and the borrower needs to understand the variables. The bank gets to continue to fund its balance sheet with variable rate deposits (checking, savings and money market accounts) and the borrower gets the desired long-term fixed rate (we can go up to 25 years). Generally, these loans only work for financing that will be in place for a long term and secured by real estate. The prepayment language is inflexible, as it’s a market-based trade, so paying early out of cash flow leads to a change in the trade and either a prepayment penalty (you pay) or premium (you receive).
- Industrial Revenue Bonds are ideal for expanding real estate with some equipment added. This is a way for manufacturers to access tax-exempt financing. If desired, these can be combined with a swap to achieve a long-term fixed rate and tax-exempt status (though not all banks have tax-exempt interest appetite). Additionally, this should be used for a long-term structure, as there are material upfront financing costs that cause the starting point to be projects of around $2MM and greater.
- Local Funding. Depending on where you’re located, there may be local revolving loan funds available for job creation. These borrowing rates are typically several percentage points below your conventional bank loans, but need to be paired with a financial institution being the primary lender into the project. The benefit is below-market financing. You’ll need to get loan approval from another group of people at the revolving loan fund besides your lender. Sometimes the financing available by these groups is from a public entity, so you could be subject to open records requests. Make sure to understand if this is the case early on to ensure you are comfortable with this situation.
As you can see, there are a number of options when seeking financing for an expansion. Talk with a business banker to understand the benefits of each and get practical guidance to help you select the most appropriate for your needs. In the meantime, you can learn more about one of the SBA loans appropriate for financing an expansion by downloading SBA 504 Loans: Basics Businesses Should Know.