In the last entry on loan repayment, I promised to describe a situation in which, as a small business owner able to pay debt early, you can lock in a good rate of return on your money.

The first and most obvious way is the direct return on money you get on early pre-payment of debt owed to banks such as lines of credit, term loans, or credit card debt. This is easy to calculate: In essence, pay off your 8% business loan and you lock in an 8% return on your money, without risk.

Clearly, the more expensive your debt, the better return on your money you receive for paying it off early. If you’re paying credit card rates of 18% or higher, the best way to ‘beat the market’ and earn a return of 18% (without risk!) is to get that debt paid right away. If your business is not otherwise earning a rate of return above that 18%, you are locking in a loss on your capital. Most businesses cannot consistently or risklessly earn above an 18% return on capital, which means most businesses should not carry balances at high rates of interest.

There’s another way to get a great rate of return paying off loans early, if you have the special situation of owing money to a private lender or a specialty finance company.

Here’s the key thing you need to know: Most every non-bank lender has a price, below the total amount owed, at which they would allow your business to repay the debt early. Your goal is to find out for how much, and when, they would take a discount.

The special circumstances vary on how the debt came about, but believe me, every one of these lenders has a discounted price known only to them on their loan to your small business.

The debt might be a note carried back by the previous owner of the company from whom you bought the business. It might be from a real estate investor who liked offering you financing because she had extra cash and didn’t mind earning a decent return for the loan.

Sooner or later, your private lender will have need for cash today – whether it be to buy a new business, a new property, or just to reduce exposure to your business - and they would accept less than the total amount owed.

Incidentally, this scenario comes with a don’t-try-this-at-home warning: Banks generally will not discount their loan to your small business, unless they think you are in serious trouble. Do not try to negotiate a discount like the above example unless you are in that situation, as banks don’t take too kindly to the suggestion of a discount. Chances are they will immediately start adverse action that will cost you more in the end.

But, if you’ve got the ability to pay off the debt early or can refinance the debt through a bank, you should strategically offer to do so with the private lender at a reduced amount. Maybe you just let your lender know that anytime they want the money back early, you could probably accommodate them for, say, 85% of principle. No rush, you say, just letting you know that if you need the money back early, it’s available.

How good is your rate of return if you’re able to get a discount like that? It helps to use the mathematics of a specific example to illustrate the rate of return discussion:

Let’s assume you owe $100,000.00 at 8% interest over the next 3 years. If you can pay the debt at 85% of the remaining balance today, you can effectively lock in not 8% (the automatic Rate of Return of repaying your debt) but instead 14.58% for the next three years.

There are very few opportunities in the financial world in which you can earn 14.58%, without risk. If you pay off the debt entirely you actually reduce risk. If you refinance through a bank, at least you lock in savings.

If you owe money to a private lender or specialty finance company, it doesn’t hurt to try to get a discount if you can. The rate of return possible through discounting the debt makes it worth the effort.

Every time in the last six months I have met someone new who

a) Reads a newspaper, and
b) Knows I own my own business,

I am asked a version of the same question, namely “How does the housing slump and mortgage-lending fallout of 2007 affect your business?”

The answer for Cedarcrest, of course, is “it depends.”

But, if my querying acquaintance has time, and if you the reader have patience, I’ll take a stab at the specific ways in which it depends.

The interactions between the slump in real estate, lending restrictions due to bank losses on sub-prime mortgages, and small business finance are varied, nuanced, and sometimes surprising.

Overall, most of us entrepreneurs should not feel the direct effect as a hit to our business but we should still be paying attention.

Will the rash of foreclosures on sub-prime home loans be followed by a rash of small-business closings? Not really. The financial linkage is not that direct. The businesses most directly hurt have been big and highly leveraged, such as Merrill Lynch, Citigroup, and nearly every sub-prime mortgage lender.

Most small business entrepreneurs are not sub-prime borrowers who have fallen behind on their mortgages. The overlap between borrowers caught up in the sub-prime trap, and small business owners who would otherwise be successful, is small.

If you believe that 20% of mortgages issued since 2004 have been subprime, and 10% of these mortgages will default, you are looking at a maximum of 2% home defaults for the entire population, and a much smaller amount than that among small business owners.

But the simplest reason for my statement is that, crisis or no crisis, borrowing at 14% for 30 years (or 8% for two years as a teaser only to be bumped up to 14%) means you weren’t going to make it as a small business owner anyway.

I understand of course that half of American households carry a credit card balance on a monthly basis, and therefore half of American households effectively borrow at between 12 and 25% interest all the time. But, most of these households are not running a small business.

I do believe the current housing and mortgage crisis is extremely important for small businesses, but I happen to think its more of an opportunity than a risk for anyone who runs a small business or dreams of starting their small business.

In the next three postings I’ll describe the links, risks, and opportunities for small businesses in the housing and mortgage crisis.

Let’s take the issues one at a time.

1. The Link between Home Ownership and Entrepreneurship
2. Ways Your Small Business Can Get Hurt in the Slump
3. Ways You can Profit in the Slump

NEXT: Home Ownership and Entrepreneurship

Let’s say you are a twenty-something entrepreneur just started down the road to owning your own business, and lets suppose I was your grizzled-veteran thirty-something entrepreneur adviser.

Further, let’s suppose you wanted to know the #1 most important thing you could do to prepare for owning your own business. I would like to think I could surprise you with my #1 piece of advice: “Buy a house first.”

Did I surprise you?

If you can survive the process of purchasing a home, and in fact be successful at it, you’ve passed the first test of entrepreneurship.

I think of the link between home ownership and small business as testing your skills, your ability to get financing, and finally, your stamina.

In terms of skills, I know I didn’t have any training before I bought my first real estate property in 1998 and my second in 1999. Each time the skills I learned prepared me unusually well for building a small business.

Take hiring a good real estate broker, for example. When my broker told me that the residential building I was buying into didn’t exactly have a perfect financial history, well, let’s just say that he was putting it mildly. The building, it turned out, was basically being run by a mobster.

The most important lesson from that experience, of course, was that my broker worked for the seller. As a small businessman, I always try to remember who people are really working for.

Later, when the real estate attorney I hired took three weeks to review a standard real estate contract, that experience too offered an important lesson in hiring people who can get things done in a timely way. I was one of dozens of clients all at the mercy of his work schedule and, most likely, his golf game.

Hiring specialists who focus on Cedarcrest continues to be a key skill for my small business.

So, too, is financing. I borrowed small amounts of money from three different family members to scrape together the down payment on my first apartment. I carefully wrote out promissory notes, figured out an appropriate rate of interest, and sweated the fact that I was breaking the time-honored rule of never taking a loan from family, at the risk of losing both money and the relationship.

The down-payment loans worked out fine in the end, and I’d like to think my family was predisposed to a financing pitch from me when I started my business 6 years later.

Another interesting financing tool I learned from my first property acquisition was owner-financing. My first real estate purchase in 1998 was raw land in a rural area of New Mexico. The seller owned the property next to mine, and offered to sell me the parcel for 50% down, and 50% over time. He kept the note and earned interest on the mortgage balance, while I was able to pay him over time for a low monthly payment.

When I had saved up enough money about a year later, I paid him off early. In this situation, a bank loan was not the most efficient way to finance the purchase, and we both ended up better off through seller-financing. I had no idea at the time how important seller-financing was as a small business tool, but it turns out to be something which we frequently work with at Cedarcrest.

Finally, the most important entrepreneurial skill learned in the process of purchasing real estate is stamina…It always takes twice as long and three times as much effort as you expected. If you can successfully make it through purchasing real estate, you’re in good standing to own your small business.

You may have noticed that I left out of the discussion above a few more advantages of home ownership as an entrepreneur, but they deserve quick mention as well.

1) Home ownership signals to banks or other investors that you are a forward-thinking, responsible, investor. At Cedarcrest, for example, one of the main things we ask before taking on a client is whether he or she owns a home, largely because of what it says about the person.

2) Even more specifically, a steady history of paying your home mortgage debt will boost your credit rating. Your 30-year mortgage debt at a prime rate represents the easiest and lowest-cost borrowing terms available to mere mortals like us, which makes it easier to establish the good track record for your credit rating. And you’ll need that good credit rating as a small business owner.

3) Home equity lines of credit are an essential tool for a small business owner having trouble getting financing from a bank, since banks really don’t like to lend against anything other than real estate. See my early post on this topic.

4) Wealth creation through home ownership is a key leg up for the small business owner, and certainly was a key for me in getting Cedarcrest started.

While I see home ownership as a key step, in fact the key step to entrepreneurship, in the next BizBox post I’ll talk about some of the dangers of the housing and mortgage slump for small business owners.

While I don’t think most small businesses should be concerned about the housing slump and mortgage crisis, at Cedarcrest I have seen signs that some entrepreneurs will be hurt badly.

One indicator is the number of businesses for sale having to do with the mortgage crisis.

A quick search of one online aggregator of businesses for sale, for example, has 51 mortgage brokers, 13 title insurance companies, and 1 appraisal company for sale. I’ll go out on a limb and say there has been a significant disruption in these small businesses currently for sale as a result of the mortgage and housing slump nationwide.

And while I bet these small businesses could be bought “cheap,” it’s not time to get out your checkbook yet. The losses in certain small-business sectors such as these will be severe.

Another indication of the link between the crisis and small business is the situations in which our customers borrowed too much against their home.

One client of ours took out a third-mortgage about a year ago against his million-dollar condominium in a hot real estate market, and purchased a coffee shop with it.

He called me a few times last year to try to interest me in a joint-venture buying real estate in his hot market. Since Cedarcrest does not buy real estate I declined to join in.

Only a year later, the coffee shop is not making enough money, and he’s behind on the mortgage payments on his condo. Both the condominium and the coffee shop are for sale and my guess is the value of his condominium has dropped by at least 25% in the past year. I suspect he’ll lose any equity he’s put into both, just to pay off his debts.

For entrepreneurs who borrowed too much against their home and business on too little cash-flow, this slump could be devastating.

While I think more small businesses will fail than usual over the next year due to the mortgage and housing slump, I still believe the crisis will not be the cause so much as the symptom of other mistakes made by entrepreneurs.

What I mean specifically is that borrowing at a sub-prime rate of interest such as 14% is almost never a good idea. No matter what the environment for borrowing, few small businesses are in a position to profit while paying such high rates of interest. The crisis will not bring many small businesses down, but it will highlight why many small businesses do not make it.

Here’s another way of saying this: If you have to borrow at sub-prime rates, odds are you’re not going to make it as a small business entrepreneur. My advice is to go back to working on home ownership as step one, pay your debts on time, and become a prime borrower. Then, and only then, should you go to step two of running your own business.

In the next BizBox post, I mention a few small business opportunities to look for in the housing and mortgage slump.