Although charities have become increasingly open to loan finance in recent years, it remains a niche activity. Indeed, only 3% of respondents to the Guardian Voluntary Sector Network's recent network survey had used loan finance in the past 12 months. The main barriers to using loan finance that these charities gave included a lack of appetite, a lack of knowledge and a lack of information.

Although loan finance is not something to be taken lightly and won't be suitable for all, there is an argument that many charities are not sufficiently open to a source of income that can bring huge benefits to beneficiaries.

Here are some things to consider:

RISKS AND MITIGATION

Of course, the obvious risk is that if a new project or activity does not yield the anticipated income, then charities may find themselves unable to pay without compromising other activities. In unincorporated charities, the trustees may even become personally liable for the debt. This is why it is critical that charities make sure they prepare thoroughly before taking out loans and only do so in the right circumstances. 

Simon Proctor, Head of Lending at CAF Bank (owned by Charities Aid Foundation), says they've been approached by charities with unmanageable debts in the past, but the root cause is usually that they didn’t take out the correct loan for their needs.

“Often charities have resorted to loans because they have driven down their reserves too much, find themselves running short, and aren't getting as much money through the door. In this situation we would suggest a recapitalisation, or perhaps a social investment bond or social lender such as CAF Venturesome which would be prioritising the social impact”.

“Alternatively, if they had considered loan finance before spending their reserves and made sure they used it to generate new income, they may not have found themselves in that situation.”

Most lenders are looking for evidence that a charity will be able to repay their loan. However, charities cannot rely on lenders to protect them, and must protect themselves by having a robust business plan. As Ian Mansfield, Senior Client Relations Manager, puts it:

“One of the things we would hope to see is the 'what if' scenario. 'What if interest rates rise in the next two years?' 'What if the charity doesn't get the income it's expecting?' This sort of planning gives charities a bit more leeway – if they're right up against it at the start, there's only one way afterwards and that's down.”

Proctor also emphasises strong internal structures and processes for sound decision-making:

“The first factor for success is what the charity's executive management team looks like. Do the people running the charity have the skill set to properly account for loan financing? The second point is whether they have got the governance controls in place to make sure they can oversee what the money is going to be used for. And finally, have they asked questions? There are no wrong questions and trustees should always interrogate the executive.”

Take a look at the main types of loan finance available for charitable organisations:

STANDARD TERM LOANS

With standard loans, an amount of money (anything up to £5m) is borrowed and then repaid over a particular period of time (2-25 years). Like overdrafts, these can be either secured or unsecured, but unlike overdrafts they cannot be recalled within the specified period of time. They are generally used for capital projects, and often have interest rates in the region of 2-4%.

JUNIOR LOANS

Junior loans are where one organisation is lending part of the money required but is unwilling to give the full amount. In order to bridge the gap, another organisation may offer the remaining amount at a higher interest rate because it is taking on the riskier portion of the loan. These can be complex and are not the norm; they often appear on larger capital deals in excess of £7m.