Small and medium-sized enterprises (SMEs) are the very lifeblood of the American economy — they comprise 99.9 percent of all businesses in the United States, create two-thirds of the jobs and drive 44 percent of the economic activity.
And yet, SMEs have had an increasingly difficult time obtaining bank loans to fund company growth, market expansions and potential acquisitions. Ever since the 2008-09 financial crisis, banks have faced increased regulation and grown more inclined to lend to larger corporations. In 2006, 10 of the largest banks granted loans to small businesses totalling $72.5 billion. By 2014, that amount had declined to $44.7 billion.
As a result, non-amortizing loans have become one of the more appealing alternative-lending options for mid-market businesses, with business development companies (BDCs) emerging as one of the top financing providers. SMEs are able to fund their growth initiatives without trying to break down an impenetrable wall in the traditional banking sector.
But what exactly are non-amortized loans? In this article, we’ll walk through how they function, the pros and cons, and a few of the most common types. We’ll even provide suggestions on what to look for in a prospective lender so you can go into those conversations feeling confident and prepared.
Let’s dive in.
What Are Non-Amortizing Loans?
Non-amortizing loans are loans that require the principal to be paid back in a single lump sum rather than through installment payments, although interest payments may be made over the life of the loan. These loans usually have a relatively high interest rate and a short duration.
While the intricacies of non-amortizing loans might be new to the average business owner, the fundamentals are familiar territory for many American consumers.
Take credit cards as a simple example. If you only make the minimum payment each month (which goes primarily toward interest) there is no fixed payment amount from month to month, and users typically pay off the entire balance, including the principal, in a lump sum. Some credit cards offer interest-free financing for new cardholders, but if the loan is not paid off in the interest-free period, all of the accrued interest may be added to the principal balance.
How They Function
The key thing to keep in mind about non-amortized loans is that borrowers are required to pay back the principal in a lump sum — i.e., a non-amortizing payment — as opposed to following an amortization schedule. Until then they must make only minimum payments, and in most cases these loans, reminiscent in many ways of a credit card, are of shorter duration and carry a higher interest rate.
Such loans are set up in this fashion to account for the growth curve of SMEs. That is, as the enterprise is growing, keeping costs to a minimum is top priority. Then, as it gains its footing and becomes more profitable, it is better able to pay off the lump sum at the end of the loan.
An example of an amortizing loan is a traditional principal-and-interest home mortgage, where the principal is paid back as a part of every set installment payment.
Non-amortizing loans allow for more payment flexibility, and borrowers can typically choose whether or not to reduce the principal balance on a non-amortizing loan by paying above the unpaid interest amount each month. After the interest is paid, however, the principal will need to be repaid, often in a lump sum.
The appeal of this type of loan to many small and medium-sized businesses comes down to its flexibility. Businesses can acquire the funds necessary for growth or expansion initiatives, and still have the extra time to pay back the principal without being locked into a set installment every month. Business owners who use non-amortizing loans expect that their income, over a period of time, will more than make up for the expenditure of the loan itself.
Pros & Cons
The major advantage of a non-amortized loan is its lower monthly payments. There is often a significant difference between the monthly costs of amortized and non-amortized loans, which can be an important factor for a business trying to keep its monthly costs low.
Of course, the loan’s structure also leads to a primary concern. The reason the payments are so much lower on a month-to-month basis is that the borrower is generally only paying off the interest while still owing the principal balance. As a result, borrowers do not build up equity in the assets purchased with a non-amortizing loan, and the final principal payment, sometimes called a balloon payment, must be paid off at the end of the loan period.
Borrowers can use a balloon mortgage or another type of non-amortizing loan to avoid large payments for years, but a substantial payment will come due at the end. This type of loan can often be difficult for individuals and homeowners, but non-amortizing loans have a different appeal in the business world. For businesses in a growth phase, non-amortizing loans can serve as an appealing source of financing, where the principal is paid back once the business has established a stronger financial footing.
Types of Non-Amortizing Loans
Different companies have different needs as they follow their growth curve. As a result there are different types of non-amortizing loans designed to suit varying circumstances.
Type 1: Balloon Loan
Balloon loans typically have a repayment period of five to seven years, and can be of the interest-only variety (more on that below) or feature monthly payments that include principal and interest, resulting in a smaller lump sum when the loan comes due.
In the case of the latter loans, most of the monthly payment goes toward interest and some toward the principal, though there is still a large payment at the end of the loan. Some mortgages are structured this way in real estate purchases.
Balloon loans can be advantageous to a business as it works toward profitability or improves its credit. In other words, the smaller up-front payments allow the enterprise to buy time while it focuses on other growth-related goals.
Type 2: Interest-Only Loans
An interest-only loan is a type of balloon loan. Here, the borrower pays only the interest over a specified period of time, while the principal is paid in full at a previously agreed-upon date. This is one common method of student loan repayments, although borrowers typically switch to combined principal-and-interest payments rather than paying them off with a lump sum.
Interest-only payments last only for a specified period of time. In most cases involving this type of non-amortizing business loan, this period lasts for five to 10 years. Business owners considering this type of loan must take care to save up and prepare for the principal repayment during that time.
Since borrowers pay nothing toward the principal during this time, the initial loan balance remains unchanged. Some borrowers may also attempt to garner a new loan for the principal balance, a form of refinancing, although they must be able to show stronger financials in this case.
In many instances, interest-only loans feature adjustable rates. The initial interest rate is often low, lasting three to five years. These “teaser” rates can rise later on, and the payments can rise and fall as the London Interbank Offering Rate (LIBOR) changes throughout the life of the loan.
Type 3: Deferred-Interest Programs
Many borrowers may be accustomed to deferred-interest programs, as they are commonly offered by retail stores financing their products or credit cards hoping to entice new borrowers. Here, interest payments may be delayed or deferred or even eliminated entirely if the loan balance is paid off in full during a specified period.
Such loans are helpful to small and middle-market businesses when they need to make a purchase that is unusually large or one that comes in the face of an emergency. Say a severe storm hits and a business needs to replace its roof. Rather than using a credit card or taking out a high-interest loan, the enterprise can resort to a deferred-interest program to meet its needs.
What To Look For In A Lender
If you’re in the market for a non-amortized loan, you’ll probably want to consider a business development company (BDC). BDCs are flexible alternative lenders with programs tailored specifically to meet the needs of small and mid-sized businesses.
Whether public or private, these institutions offer a wide range of funding options, ranging from equity financing to debt financing to hybrid options, and work with SMEs and their owners to develop sustainable funding options that benefit both parties. Moreover, these options will not put those owners in a position where they must sacrifice managerial control.
Further, BDCs provide smaller companies with simplicity, speed and flexibility, three things especially appealing to companies of that size, as they often have a variety of unique, individualized circumstances. Banks generally do not make such provisions.
However, not all BDCs are the same and it’s worth doing some due diligence to gauge the reputation of the lender and its track record before you move forward. Similarly, lenders typically focus on particular industries, or certain company sizes with specific revenue brackets, so it’s a good idea to check each company’s investment profile during your search.
When choosing a lender, it is also wise to take transparency into account. Make sure you understand the interest rates and fees before signing a funding contract; this is the first step toward a sustainable repayment and growth process. In addition, keep each lender’s requirements in mind to make sure you find an alternative financing institution that can best service your company.
Conclusion
The COVID-19 pandemic has emphasized many of the trends that began in the wake of the ‘08-09 financial crisis. Banks remain hesitant to lend to small and mid-sized enterprises, and alternative lending options like non-amortizing loans remain appealing to small and medium-sized business owners, especially given the restrictions associated with traditional bank loans.
The specific advantage of non-amortizing loans is that the low monthly payments make it possible for a smaller organization to meet its debt obligations while simultaneously growing the business. The downside is just as obvious, however: There is a large lump sum awaiting at the end of the loan, and if a business does not meet its objectives, that could pose a problem.
Generally, however, this is an option that small and mid-sized businesses would do well to keep in mind, as it offers the sort of flexibility and simplicity that characterizes all forms of alternative lending and stands in stark contrast to the highly regulated banking sector.