When it comes to getting a business loan, the right question to ask isn't how much you can borrow. Responsible borrowers should ask "How much should I borrow for a business loan?"
Read on to learn about the considerations you should make to decide on a business loan amount.
Why is how much I borrow for a business loan important?
Business owners who take out a loan without proper planning do so to their detriment. Why? Whether a business loan is short- or long-term, it has far-reaching consequences.
A loan that is too large can disrupt your business's cash flow. It can prevent you from forecasting your financial future. Moreover, it can affect your ability to secure a loan at a later time.
On the flip side, an inadequate loan can impede your business launch. It can stymie your ability to carry out day-to-day operations. It can also prevent you from meeting crucial financial commitments to business partners.
Your goal should be to pick a loan amount that keeps your company afloat without drowning it in debt.
What's the average small business loan amount?
Based on Federal Reserve data, ValuePenguin put the average small business loan at $663,000 in 2018. But the amounts varied by the lender.
For example, alternative lenders handed out small business loans of $50,000 to $80,000 on average. U.S. branches of foreign banks skewed the results by doling out a whopping $8,512,000 in small business loans.
How do I decide how much to borrow for a business loan?
The answer to the question "How much should I borrow for a business loan?" depends on a variety of factors:
- Business needs. Borrow an amount you need based on data, not on the amount you want based on wishful thinking. Do an exhaustive analysis of fixed and variable expenses to come up with projected costs. Your loan should at the very least cover these projected costs.
- Ease of repayment. Your monthly income should more than compensate for your monthly loan payments. Components of a loan payment include principal, interest and any upfront fees. Otherwise, the loan amount is beyond your means. It's helpful to analyze your debt-to-income (DTI) ratio to assess the ease of repayment. Aim for a DTI ratio of 36 percent or less to be on the safe side.
- Forecasting. You will continue to make payments on a business loan for the length of the loan or until you pay it off. Are you willing to shoulder the monthly loan payments not only now, but a year or years from now? A larger loan amount with a longer term may force you to make sacrifices. For example, you may not be able to fit both loan payments and R&D on a new product in the same year.
- Loan profitability. In an ideal scenario, the total revenue you earn from the use of the loan should surpass the total costs of the loan. Settle on the smallest loan amount from which you can generate a profit. Extra loan dollars may not be worthwhile if you cannot put them to work in a meaningful way.
- Future loan prospects. Do you plan to take another loan out in the future? You may want to reduce to amount you borrow now to keep your total debt burden down in preparation for a future loan.
- Lender assessment. Your loan amount will come down to how much a lender is willing to give you. Lenders assess your creditworthiness and risk in many of the same ways above. In some cases, a lender may be willing to loan more money than you need. But it's important only to take on a loan amount you know you can handle.