If you are looking to launch a business or grow a company but don’t have adequate funds, there are a number of financing options you can consider. The No. 1 source of funding for businesses are conventional bank loans. For younger firms with less credit history or businesses that don’t qualify for traditional loans, however, Small Business Administration (SBA) loans are a good choice. Here’s what you need to know to determine which type might be right for your business.
SBA loan vs. conventional business loan
Both SBA and conventional business loans are usually issued by banks. SBA loans, however, come from banks that participate in the SBA loan guaranty program. Under these loan programs, the SBA promises that if your business fails and you default on the loan, it will buy a portion of the loan back from the bank. An SBA guaranty typically ranges from 50 percent to 85 percent of the loan amount up to $3.75 million.
One of the main differences between a conventional business loan and an SBA loan is the loan amounts and terms. SBA loans typically have longer terms and lower interest rates than conventional business loans.
How conventional business loans work
Conventional business loans are typically offered by banks, credit unions and other financial institutions. These lenders provide funds as a lump sum to an approved business, and the business repays the loan over an agreed-upon term, plus interest and any applicable fees.
Depending on your loan agreement, business loans can be used to expand your business, for business-related equipment and real estate or as working capital.
With a conventional business loan, the bank shoulders 100 percent of the risk if your business defaults. Since conventional business loans are high-stakes for private lenders, banks often require borrowers to have good credit. You’ll also need to demonstrate the business’ ability to repay the loan, and you are expected to provide a business plan that outlines your business’ details and financial projections.
Pros and cons of conventional business loans
Conventional business loans may be a good option for established businesses, but it’s worth considering the pros and cons first.
- May offer competitive rates.
- No borrowing caps.
- Variety of loan terms available.
- Flexible monthly or annual payment schedules.
- Approval process is generally faster.
- Requires strong business and personal credit scores.
- Higher interest rates for bad credit.
- Approval for new businesses can be difficult.
- Not backed by the U.S. government.
Who conventional business loans are best for
Established businesses who’ve been in operation for many years with a track record of positive financials have the most to gain from a conventional business loan. If you and your business have high credit scores, private lenders might be more inclined to offer a competitive interest rate. Low rates help you save money on the cost of borrowing, and fixed rates give you a predictable monthly payment.
How SBA loans work
The SBA is a government agency whose purpose is to assist and advocate for small businesses in the U.S. Through the SBA Loan Guaranty Program, the agency partners with SBA-approved private lenders to offer a variety of SBA loan options. Depending on the type of loan you get, the SBA eliminates a percentage of the risk banks take on when funding young businesses.
Although SBA loans may require more paperwork and take longer for approval, they offer businesses a variety of loan types. The three biggest SBA loan types are:
- The 7(a) loan program. As the SBA’s most popular loan program, 7(a) helps businesses finance startup costs, buy equipment and inventory and obtain working capital in amounts up to $5 million. It can be used to launch a business, buy an existing business or expand a business. To qualify, the business must operate for a profit in the U.S., and the owner must have an equity stake.
- The 504 Loan Program. This program provides small businesses with long-term, fixed-rate loans to buy assets for expansion and modernization. The loans are offered through Certified Development Companies, which are nonprofit corporations that promote economic development and are regulated by the SBA. The loans typically require the borrower to contribute 10 percent of the project’s cost.
- SBA Microloans. The SBA provides funds to intermediary lenders — typically nonprofit community-based organizations — to manage smaller loans of up to $50,000. Businesses can use the loans for working capital or to buy inventory, furniture and equipment, but they cannot use the loans to pay debts or purchase real estate. The average microloan is $13,000.
These SBA loans have specific eligibility requirements that businesses must meet in addition to lenders’ own underwriting criteria. SBA loans require businesses to meet its small-business size standards and are only available to businesses that would otherwise not qualify for a conventional business loan.
Pros and cons of SBA loans
Before choosing an SBA loan, consider some of their benefits and drawbacks.
- Offers small and large loan amounts.
- Designed for new businesses and startups.
- Longer repayment terms of up to 25 years.
- Loan is guaranteed by the government.
- Option for businesses with bad credit.
- Must meet SBA and lender requirements.
- Paperwork and approval can take longer.
- Lenders might require collateral for certain loans.
- Different loan programs can be confusing.
Who SBA loans are best for
SBA loans are best for new businesses that are operating in the U.S. and which haven’t been in operation long enough to build a strong credit history. Loans backed by the SBA also serve a variety of loan needs, like smaller loan amounts or longer repayment terms.
If you’re at the beginning of your search and considering an SBA loan versus a conventional business loan, you’ll want to explore both options before making a final decision. Keep in mind that just as no two conventional lenders are the same, neither are SBA lenders.
And since you’ll need to exhaust your financing options to be eligible for an SBA loan, exploring conventional business loans can be a helpful first step. Whichever direction you take, it’s a good idea to shop around and choose a lender that understands your business goals and needs.