How Business Loans Work

As a budding entrepreneur, you want to learn all you can about how business loans work. Small business lending can give you the funds needed to build or expand your business and help you reach your full potential.

This guide discusses everything you need to know about how business loans work. From there, you can determine which one may be right for your company.

What are business loans?

A business loan is a way for small business owners to get the cash they need to grow their businesses.

There are many reasons for seeking a business loan. Someone who has just started building their company may need working capital for office expenses, staffing, payroll, inventory, equipment, or other items while they build positive cash flow.

On the other hand, a business that has already been operational for some time may decide to expand. You may want to acquire another company, buy real estate, increase your inventory, renovate your business, get new equipment, or use the loan for business expenses during an unexpected crisis.

There are different types of business loans for each of these needs, each having distinct features that may or may not be suitable for you or your business.

How do business loans work?

To apply for a loan, you’ll have to submit paperwork and information about your business as part of the loan application process, so the lender can determine whether or not you qualify for a business loan. In doing so, they’ll evaluate many factors, including:

  • Your credit history
  • The industry and type of business
  • The amount of cash flow you have on hand
  • Any potential business loan collateral you can use in the loan
  • How much debt your business can take on
  • Your business plan and intended use for the small business loan

The terms and requirements for each type of small business loan vary, as do the specific requirements you’ll need to provide to your lender. Every business also has diverse needs, so it’s important to consider which type of business loan may work best for you.

Types of small business loans

There are several different kinds of small business financing options, each having distinct benefits and limitations. Here are a few of the most common:

Working capital loans

Working capital loans can be used for one-time business expenses, equipment or inventory, staffing, expanding your business, and other needs.

These types of loans can also help cover occasional shortfalls in operational expenses, such as when your account receivables are lower than expected or if you operate a seasonable business. A working capital loan will help cover and replace the short revenue in those instances so you can run your business without interruption.

SBA loans

U.S. Small Business Administration loans are obtained through SBA-backed financial institutions, and the SBA guarantees the loans in the event of a default.

While SBA loans typically have lower interest rates than other loans, they’re harder to qualify for. You’ll need a robust credit profile to meet the rigid qualifications.

Further complicating things, the application process is often long and tedious. But, if you do qualify for an SBA loan, you’ll likely have a longer time to pay back the loan, and those lower rates can be very appealing.

Term loans

A term loan consists of a fixed amount of cash that you receive upfront and repay with interest over a predetermined amount of time. For instance, a business owner might borrow $100,000 and finance it through a term loan with a repayment term of three years at an interest rate of 8%.

You’re often able to borrow more money when you finance your business with a term loan than with some other types of business financing.

To get approved for a business term loan, you’ll need to have a solid credit score and record. In addition, some lenders may require collateral, such as your business’s assets or real estate, to secure your loan. Term loans are a good option if you’ve been operating your business for some time and have seen relative success.

Commercial real estate loans

Commercial real estate loans are used to purchase new real estate or leverage the equity you already have in real estate to grow your business. You can also use a commercial real estate loan to refinance other loans or pay for renovations.

If your business brings in annual revenue of $250,000 or more, you already own commercial property, and your company has been open for 18 months, a commercial real estate loan may be right for you. And because the real estate is used as collateral, some commercial real estate lenders only require credit scores of around 660.

Personal loans

Personal loans are typically easier to get than small business loans, particularly when you have good credit and manage your personal finances well. But, if you default on a personal loan, it can ruin your credit standing.

While personal loans are typically used for personal purchases, sometimes they’re used for business reasons. This is especially true for borrowers who plan to use the money to begin a new business. If you are willing to accept the risk, a personal loan for your business may be an option.

A personal loan lender will use your personal credit history to determine whether or not to approve you. This is different than the business loan process, which typically factors in both your personal and business credit scores, as well as other criteria regarding your business.

Most business loan lenders prefer that a business is already successful before giving out even a short-term loan, as this increases the chances that the loan will be repaid within the terms specified. Because of this, many business owners begin by investing in their own company, often through a personal loan.

There are higher borrowing costs associated with personal loans than with typical business loans. You may also be limited to borrowing a smaller sum of money, usually under $50,000.

Merchant cash advance

With a merchant cash advance, you receive a lump sum upfront to use for your business, but repayment is very different than with a term loan.

Rather than the fixed monthly payments, you would typically make, you withhold a percentage of your credit card sales or business receipts to repay the loan. A borrower can also repay the debt through fixed withdrawals from a bank account.

The clear advantage is that you have quick access to the funds your business needs. It’s also unsecured, so there’s no need to have collateral. However, merchant cash advances are similar to personal cash advances in that it’s prohibitively expensive, often up to 350% of the amount advanced.

In the end, your business can develop serious cash flow issues from the frequent repayments.

But, if you have bad credit or a hard time getting financing, a merchant cash advance may work for you, particularly if you have a continuous flow of sales and can deal with the constant repayments.

Invoice factoring and invoice financing

Invoice factoring and invoice financing aren’t loans, per se. If your business has invoices that customers aren’t paying and you need additional cash for your business to operate efficiently, invoice factoring or financing could be a solution.

With invoice factoring, you sell the unpaid invoices and lose out on the entire revenue and control of the invoices (but don’t have to follow up on the customers either).

With invoice financing, you retain the unpaid invoices and use them as collateral for a cash advance, essentially financing the outstanding invoices. You still have the burden of collecting payment for the invoices.

With either option, you receive cash quickly for your business. But there are fees and other charges you have to pay, and when you factor those things in, both can be costly options.

Equipment financing

Equipment financing can help you purchase much-needed equipment for your business. The life of the loan will equal the life span of the equipment you purchase for your business because the equipment serves as collateral for the loan.

One advantage of this type of financing is that you build equity and have ownership of the equipment. This is a more attractive option to most business owners compared to renting their equipment.

If your credit is strong and you’ve handled your business finances well, you can get better rates on the loan.

Some lenders will still require a down payment, particularly if a vehicle is part of the equipment purchase.

Where to get a business loan

You have many options when it comes to getting a small business loan. They include:

  • Online direct lenders: Reputable online lenders like biz2credit will approve you more quickly than a traditional bank as they specialize in offering direct loans to small business owners. You’re also likely to get the cash you need faster.
  • SBA-backed lenders: These banks provide business loans guaranteed by the Small Business Administration. SBA lenders usually require lower down payments and offer a longer-term loan with a lower interest rate. But these loans can be more difficult to qualify for.
  • Traditional banks: This category includes large commercial banks, smaller community banks, and even credit unions. It is typically harder to qualify for these loans as the credit requirements are stringent.
  • Peer-to-peer lending: Peer-to-peer loans are funded by a group of investors instead of one lender. Because of this, peer-to-peer loans often have higher interest rates because each investor is looking for a return on their investment.

Small business loan application checklist

Before applying for a small business or startup loan, you’ll need to gather the following documentation for the loan application process:

A business plan

Most lenders require a sound business plan that is sustainable and achievable. To assess this, a lender will want to view your financial statements, learn more about your business strategies, and gauge your financial plan.

You’ll also want to detail what your business is and which products or services you offer. A good business plan will convey your ability to lead your business to success.

Business credit report

Lenders will want to examine your business credit report, particularly if you’ve been operating for a while. If you have any blemishes that have lowered your business credit score, you’ll want to address them before attempting to get a business loan.

Financial statements

Financial statements allow a lender to evaluate your business’s financial standing. These statements include profit and loss statements, a balance sheet, cash flow documents, income statements, bank statements, and future profits and sales predictions.

Income tax returns

Most financial institutions require you to submit the last three years of business and personal income tax returns as part of their loan process.

Accounts receivable

Many lenders will want to examine your business’s current financial standing. To do so, they will want to look at your business’s accounts receivable and payable records.

In addition, they may require other items when you apply for a business loan. These include a loan application form, collateral (when required), and applicable legal documents, such as articles of incorporation, copies of your business license, and commercial lease or franchise agreements.

The Bottom Line

The bottom line is that if you need a business loan, be sure that the loan works for you, and helps you achieve long-term success. Don’t accept a loan with requirements that you can’t afford to repay. And be sure to look at all your options. For example, you may find that for some purchases, a business credit card might meet your needs better than a loan.

Now that you understand how business loans work and the type of loans available to you, you can make an informed decision about which loan is right for your business.

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