There is a huge difference between consumer credit and business credit. Consumer credit funds consumptions while business credit is known as “leverage” and is applied to the purchase of an income-producing asset.
As individuals, consumer credit is generally a method we use to obtain what we desire sooner than if we were forced to save up the funds to purchase the item. In most cases, no objective decision-making criteria is applied to purchases made with consumer credit.
Growing up, my parents were keen to tell me that they never bought anything they could not pay for with cash. For them, consumer credit was really never an option. They even bought their house with cash after many years of saving.
The matter of credit is made worse when credit is used to buy non-assets such as a T.V. or a night out which will be paid back over an extended period of time with interest tacked on. The best definition I’ve heard of an asset is by Robert Kiyosaki of Rich Dad, Poor Dad fame where he postulates that “an asset is something that makes you money.”
A non-asset such as a T.V. or a car depreciates the moment you buy it and continues this decline in value until it reaches zero. An asset, by contrast, either grows in value or contributes a cash flow in some way or both. For example, if you buy a lawnmower to mow your own lawn it is not an asset. However, if you use the lawn mower to cut your neighbor’s lawn in exchange for some type of payment, it would be considered an asset.
It is no surprise that individuals new to the business world often extend what they know about consumer credit to business credit situations and then wonder why a bank or other lending institution denies their loan applications. The fact is that credit is viewed quite differently in a business setting.
In business, credit is “leverage”. To explain, the bank or lending institution extends credit to the business and charges an interest rate based on perceived repayment risk. The riskier the debt, the higher the interest rate they charge. Leverage comes from the fact that the business intends to use the borrowed funds to achieve a higher rate of return than the cost of the loan.
For example, my business owns the land and building where we have a restaurant as a tenant. The cap rate (the amount of expected return on an investment after accounting for expenses) when I bought the property was about 7.5% and the mortgage for the property was roughly 6%. Essentially, we are leveraging the bank’s money loaned at 6% to make 7.5% where we get to keep the spread or 1.5% for the additional risk assumed by our business.
When it comes to business credit, it is all about the return on investment (ROI). Throw out your experiences with consumer credit since they don’t apply in business. Consider business debt for the leverage it will afford the business. So, the next time you think, “I could sure use a business loan to start or expand my business,” you better have a specific plan for the funds that will generate an overall greater return (appreciation and/or income) than the cost of the loan (principal and interest). Otherwise, the loan is not worth obtaining.
When you think of credit, do you think of leverage?
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