How do business loans work?
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Key takeaways
- Business loans can be secured or unsecured, but all have set repayment periods, terms and interest rates
- Approval for a small business loan typically requires a good credit score, solid business revenue and a personal guarantee or collateral
- There are many potential lenders for a small business loan, including online lenders, banks, credit unions and peer-to-peer lending sites
If you’re considering launching a small business or the time has come to expand operations, a small business loan may be able to provide the money needed to achieve your goals.
There are many different types of small business loans, and the requirements to qualify for each, such as the available loan amounts to be borrowed and the repayment terms, vary. Learn more about the loan process and decide on the financing option that best suits your needs.
What is a business loan?
Business loans are funding that can be used to help start or grow a business. These loans can be used to fund large, one-time expenses or expansion. They can also cover the costs of operating your business, including paying for salaries, office supplies and inventory.
Types of small business loans
How you plan to use your business loan impacts the type of small business loan you choose. For some business owners, the funds may be used to cover day-to-day operations, while others are interested in purchasing equipment or vehicles.
The below common types of business loans have varying loan amounts, interest rates, fees, eligibility criteria, possible uses and repayment terms.
| Loan type | Purpose | Best for |
|---|---|---|
| Term loans | Working capital and other short- and long-term business expenses | Businesses with expenses of varying sizes that need to be covered |
| SBA loans | Working capital, payroll, expansion, equipment, real estate and large equipment | Businesses that want low-interest rates and the options for longer repayment |
| Business lines of credit | Payroll, supplies, inventory, working capital and other short-term business expenses | Businesses that need flexibility with their borrowing |
| Equipment loans | New or used equipment, including vehicles, medical devices and machinery | Businesses purchasing new or used equipment |
| Invoice factoring/Invoice financing | Working capital, payroll, inventory, supplies and other business expenses | Businesses with a need for cash to cover operating expenses but have limited options for borrowing |
| Commercial real estate loans | Commercial real estate purchase or lease | Businesses looking to open up a physical location |
| Microloans | Inventory, supplies and working capital | Startups or new businesses with low annual revenue |
| Merchant cash advance | Working capital | Businesses that need a short-term boost in capital |
How do business loans work?
Businesses considering a small business loan can choose between secured and unsecured business loans, which are repaid over a set period, including interest and fees.
A secured loan requires you to put down collateral, while an unsecured loan does not. Loan collateral might be the equipment, real estate or other asset you acquired with the loan funds, but it can also be money. If the borrower fails to repay or defaults on the loan, the lender can take possession of the collateral to cover the borrowed amount.
While unsecured loans don’t require collateral, they often require a personal guarantee, meaning you and other business owners pledge responsibility for repaying the debt.
Here’s a closer look at how a few popular types of business loans work.
How do term loans work?
Term loans provide a lump sum of cash that is paid back over a set period of time, typically between two to five years. For applicants with good credit scores, these loans often come with competitive interest rates.
The application and funding timeline for term loans may also be relatively quick, depending on the lender. Online lenders can often approve and possibly fund in less than a day. But if you have less than ideal credit, a lender may require that you provide a personal guarantee to obtain funding. This means you agree to repay the loan with your own money if, for some reason, your business cannot meet the loan obligations.
There are various types of term loans, including options designed for equipment financing and to provide working capital.
How do SBA loans work?
SBA loans can provide operating capital or be used to cover other business expenses, including expansion and large purchases. These loans, partially guaranteed by the U.S. Small Business Administration, are known for having low rates and long repayment periods, making them a particularly affordable borrowing option. But they also take the most time to apply for and have strict qualification requirements. Often, these loans require a good credit score and solid business revenue.
SBA loans have strict qualification requirements and a slower funding timeline while often requiring a good credit score and solid business revenue. That said, there are options available for those with bad credit or newer businesses.
The SBA’s weekly lending report shows that over $5 billion of approved funds have gone to startups that will use the funding to open their doors. Additionally, several online lenders offer lower credit score requirements, like Lendio and Creditfy. Each accepts a minimum credit score of 600 for SBA loans, compared to the minimum credit score of 650 or higher required by more traditional lenders, like Live Oak Bank.
To get an SBA loan, you apply through an SBA-approved lender. This will require extensive documentation, including personal and business financial statements, a business plan and SBA-specific forms, such as SBA Form 413 and 1920. Most SBA loans also require a down payment and personal guarantees.
How do business lines of credit work?
Business lines of credit offer a more flexible borrowing option. They allow business owners to borrow as much or as little as needed, drawing on the funds as necessary. Like a business credit card, lines of credit come with a renewable spending limit, meaning the available credit is refreshed as you repay it.
Funds from a business line of credit can be made available relatively quickly, often within a business day, when working with an online lender. The money can cover business expenses, such as paying employees or purchasing inventory. But lines of credit typically come with smaller funding limits than traditional business loans, so they may not be able to cover significant expenses or funding needs.
You may also pay higher interest rates on a line of credit than other types of loans. Lenders aren’t required to display their rates for credit lines. But some may charge as much as 60 percent, depending on your creditworthiness.
How do invoice financing and invoice factoring work?
Invoice financing and invoice factoring are similar types of short-term borrowing. Invoice financing involves using your business’s accounts receivables — unpaid invoices owed to your business by clients — as collateral to obtain a short-term cash advance. Once your client pays the invoice, you must repay the lender for the money you borrowed. You will also pay any fees for the loan.
Invoice factoring involves selling your business’s unpaid invoices to a third-party invoice factoring company. The factoring companies pay you anywhere from 85 percent to 90 percent of the value of the invoices. Once your client pays the invoice, the lender sends you the remaining amount after subtracting lending fees.
Both invoice financing and factoring can be valuable options for business owners with bad credit or for startups that do not have much of a borrowing track record yet. The downside to this level of accessibility is that these loans tend to cost more than term loans and lines of credit.
How do merchant cash advances work?
A merchant cash advance (MCA) is an advance against your business’s future sales, specifically debit and credit card sales. The advance is provided in a lump sum of cash, which you repay with a percentage of your future sales. The lender will also take its fees from your future sales.
MCAs are typically a short-term form of borrowing offered by online lenders. And often, you’ll pay a higher APR on cash advances than other types of business loans. It’s possible for interest rates to soar into the triple digits with MCAs, so business owners should proceed carefully before seeking out this type of business financing.
Approval for MCAs may be possible with subprime credit, sometimes as low as 500. But to qualify, you’ll need to provide details about your business and its track record of income from credit and debit card sales.
Where to get a small business loan
You can access small business loans through online lenders, banks, credit unions and peer-to-peer lending sites, with each lender offering various business financing options. The lender you choose is just one of many factors that impact the cost of your business loan, so you want to choose wisely.
If you’re interested in a small business loan from a bank, here are some banks offering business loans:
If you’re interested in a small business loan from an online lender, a few of your options include the following:
There are possibilities for small business funding outside of business loans if you aren’t able to meet lenders’ requirements. Two options include:
How to qualify for a small business loan
No two lenders are the same, meaning your odds of approval vary. If your goal is to get a business loan, you want to consider more than just the lender, loan type and loan amount.
You’ll also want to confirm each lender’s lending criteria to help you decide if your business qualifies. Although lenders use the information differently, loan approval for small business loans is often based on similar factors:
- Credit score: It is typically recommended to have a personal credit score in the low to mid 600s or higher. Some lenders may accept a credit score in the high 500s. Lenders may also want to see your business credit score.
- Cash flow: Be prepared to share bank statements and business tax returns.
- Earnings: Many lenders set a minimum annual revenue, typically starting at $100,000.
- Time in business: Depending on the lender, a minimum time in operation of six months to two years is required. But some lenders are open to working with startups.
- Debt load: A decent debt-to-income ratio demonstrates your business’s ability to repay additional debts. Businesses with too much debt will have difficulty being approved for new loans.
- Security: Many lenders require collateral to secure the loan. This can be real estate, equipment, cash or a blanket lien on the business.
- Industry: Certain industries are more likely to qualify for a loan than others. Lenders look to minimize their risks by limiting lending to businesses operating in failure-prone industries, such as food service. Many also decline to lend to businesses related to gambling, weapons, cryptocurrency and marijuana.
Before applying to a particular lender, research it to see whether your business can meet its requirements.
What are the documents required for a small business loan application?
Apart from the qualifications listed above, business loans often require some or all of the following documents:
- Personal and business information: Social Security numbers for business owners and the names of primary business stakeholders.
- Business licenses and registration: Since the government administers business formation and licensing, borrowers must gather various documents related to their business formation and licensing from the government.
- Legal documents: If your business is a corporation, you will need to provide corporate documentation. If it’s a limited liability company (LLC), you’ll need to provide LLC documentation.
- Business plan: A solid business plan, including projected financial statements.
- Proof of equity (if applicable): Provide the lender with proof of ownership.
- Financial documents: Lenders typically request business bank account statements, personal and business tax returns, balance sheets, income statements and a business debt schedule.
A business plan should outline your financial goals for the business, your strategies for reaching those goals and your ability to repay the loan. Effective business plans justify the need for funding, explain the amount of money requested and provide a clear explanation of how the funds will be used and how the loan will be repaid.
The bottom line
Small businesses have access to many loan options from a variety of sources. These loans work similarly to any other loan type. You’ll apply for the loan, receive funding once approved and work to repay the loan on a set schedule.
If you have a new business and are ready to take it to the next level, shop around and be open to different lenders, including online lenders, large banks and peer-to-peer lending sites. With so many loan programs available, it’s vital to research the requirements and interest rates before applying for a loan.
Frequently asked questions about business loans
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It depends on the type of business loan you’re applying for. Most SBA business loans have strict qualification requirements. But merchant cash advances, invoice factoring and invoice financing are often easier for applicants with poor credit but come with higher interest rates and likely shorter repayment terms.
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Taking out your first business loan requires choosing a loan type and finding a lender. Once you find a lender that’s a good fit, you can apply for a business loan. It may require you to submit business documents like a business plan and financial statements.
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Typically, lenders require the collateral used to secure the loan equal to 100 percent of the loan amount. If you take out a secured business loan, the value of your collateral should equal the amount you plan to borrow.
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