Why Loans with a Rising Payment Schedule is a Bad Idea
If you look on page 35 of the July issue of Inc. Magazine the article submitted by the reader describes of his upcoming problem with the bank. No longer able to afford the monthly mortgage on the warehouse that houses his business, the owner decides to accept an offer from the bank in order to avoid foreclosure. The owners agreed to turn over the deed to the bank which gave them a five-year lease on the property in return. The terms of the lease however involved a stepladder payment schedule in which lease payments would be lower in the first 2 years but significantly increase in the last 3 years. In this case, payments during the first year was $35,000 but more than doubles to $80,000 during the fifth year. It is in year three that the owners realize that they cannot afford the $62,000 payment.
Although the terms of the agreement are definitely questionable on part of the bank a rising or stepladder payment schedule in general is a bad idea. The same applies for any kind of loan product whether for business or residential purposes. The problem with a stepladder loan is that it hinges upon your ability to grow your business at a pace that allows you to comfortably meet your loan payments. Most business owners however significantly underestimate the amount of revenue growth needed partly because a company’s variable costs will rise every time there is an increase in revenue. The example above is a stepladder loan taken to extreme.
As a simple example, let’s just say you own some type of service business and your gross overhead expense is 50%. Therefore for every dollar in revenue you generate it costs you 50 cents. Now let’s say you want to buy product X which costs $2. You can’t just reason that all you need to do is sell an extra $2 worth of services to justify the extra expense. Matter of fact in order to afford this expense you must sell $4 worth of services to justify the extra $2 expense since your overhead expense is 50%. If you apply the same reasoning to the above problem, you are talking about having to generate some significant revenue growth in a 5 year span in order to afford that $45,000 (43%) increase in rent in year five.
The point to be taken here is that no matter how tempting it is to accept a loan with a rising payment schedule, go with a loan with a fixed payment! You will know exactly what your payment will be from the very start and will do everything in your power to make sure you can cover the payment. This is every bit mental as it is physical. Think about it, wouldn’t you rather have to mentally adjust to one payment rather than to 5? Imagine, just when you finally can afford your loan payment along with your other expenses, you are forced to grow your business again because the loan payment will increase in a few short months. Sure we are all in business to grow but it would be nicer to grow with less stress in our lives?
The bank may argue the point that you will have more flexibility to manage your cash flow in the beginning and that your payments will increase as your business grows. Again this is true but can be very difficult to do. In my opinion the best payment schedule is one that has a fixed payment but your first payment is not due until 90 days. If you are disciplined you will be frugal with your cash in the early days of your business and only spend when absolutely necessary. Spending too much on unnecessary expenses is one of the fatal flaws of most beginning entrepreneurs. It is very tempting to spend the working capital you have simply because it’s there. Vendors will call on you, consultants will offer you services that claim will increase your revenues immediately or you just may simply splurge on a piece of technology that you must have but don’t need.
The other major advantage of a fixed payment schedule is that you will simply build equity in your business routinely unlike a staggered loan in which the interest will be “top heavy” in the beginning and you build most of your equity in the latter part of the loan. This is a significant point just in case you need to refinance or take out another loan. You simply will look much better on paper.
With a graduated payment loan you just never know what lies in the future. Could anybody have ever predicted that we currently would be in a recession with double digit unemployment, rising foreclosure rates and rising taxes? Now imagine having a loan payment that will increase by 20% while at the same time revenues are dropping by 30% as a consequence of the recession. Unless you have a large cushion of savings, most businesses can’t afford a major fluctuation in revenues and expenses, matter of fact many can’t even afford a minor fluctuation. The combination of stricter bank lending requirements and negative equity in your business provides the final punch which may put you out of business because you can’t get a loan to get you through this difficult time. Having successfully repaid back not one but two business loans both with graduated payment schedules concurrently, I can tell you from experience that I made the wrong decision and that I would have saved myself a lot of stress and money if I had chosen a loan with a fixed payment. In hindsight the money I spent on unnecessary expenses would have covered the higher but fixed payment during the early days of the business. If anything I just did not have the forth sight and confidence. Learn from the mistakes of others. If your situation makes good business sense be confident and go with the fixed payment loan.
