What are small business loans and how do they work?
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 could provide the money needed to achieve your goals.
There are many different types of small business loans. The requirements to qualify for each, such as the available loan amounts and the repayment terms, vary, but all offer financing to help grow or launch your business. Learn more about small business loans and how they work to help decide what financing option best suits your needs.
How do business loans work?
Small business loans involve borrowing money from a lender and then repaying the amount borrowed over a set period, including interest and fees. Businesses considering a small business loan can choose between secured and unsecured business loans.
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 and 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, and they often require a good credit score and solid business revenue. That said, there are options available for those with bad credit or newer businesses.
Several online lenders, like Lendio and Creditfy, offer lower credit score requirements. 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.
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 |
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.
