How Small Business Loans Work
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Your small business might be getting ready to make its next big purchase. Or, you might have been experiencing some unforeseen large costs in your new business. Alternatively, you could be trying to manage your cash flow more efficiently. In all cases, you are probably looking for a small business loan.

Small business loans work. They can be an efficient and effective way to help save, grow, or improve your small business operations, depending on the circumstances. Yet, navigating the seemingly endless amount of loan options available to your business can be overwhelming. This can be enhanced by the fact that getting the right kind of debt is important to ensuring your small business’s profitability.

The good news is that you have come to the right place. This post will help you understand small business loans in the context of your small business needs, the types of loans available to your small business, the small business loan application process, and what lenders will look for in your small business application process. We’ll cover the following topics in depth in this article:

Understanding Small Business Loans

The world of small business loans can be a complicated realm to understand. Nonetheless, it remains important to your small business to be able to understand its funding needs and how to supply the right financing mechanisms to it.

Perhaps the easiest place for your small business to start is to consider the purpose of why you are looking for a small business loan. It might be helpful to review a few scenarios to better understand the financial needs of your situation, small business, or startup.

If you are running a small agricultural business, such as a farm or food processing plant, you might want to expand your operations. This might include more acreage for your farm, or it might be an extra expansion of your packing facility, which requires more land. In other words, your small business might need to purchase real estate. Since real estate can be a large purchase, especially in low-margin, capital-intensive businesses, a small business loan might be warranted.

You might not be interested in real estate, but your small business might have construction needs. You might be trying to remodel a small hometown retail store you own. Or, you might want to build an outdoor patio for your restaurant. In either case, these larger capital expenses might be too much for your small business. Seeking a small business loan can be a great idea to help your small business cover the cost.

Alternatively, your small business might be doing very well. You may have a large amount of cash flow stemming from a really successful bakery. You can keep a certain amount of cash in the business to help fund regular expenses like inventory and employee wages. However, it might be time to take the extra cash out of the business and into your pocket. You may want to do this frequently for your own cash flow. If your business then faces some unknown expense, you can have a business line of credit loan to help your business during a one-off occasion.

Another situation you might consider is if your small business needs to buy some equipment. If you are running a cafe or restaurant, you might need to buy an industrial or commercial refrigerator. This tends to be a large expense for a business, and you might want to explore financing options. In this case, there are financing options available to you.

These scenarios are examples of many common types of business loans to small businesses. You should consider what you might be looking for help on financing for your small business. This can help you narrow down the types of loans and understand how the relevant types of loans work with your small business.

Types of Small Business Loans

There are many types of small business loans, ranging from the type of lender to the purpose of the loan. Each can come with varying repayment terms, interest rates, repayment periods, and more. The options are seemingly endless. To start, it is best to consider the purpose of your loan and what you want to spend the money on. Then, you can get an idea of the small business loan that is right for you.

SBA Loans

SBA loans are loans that are supported by the U.S. Small Business Administration. The Small Business Administration (SBA) helps to back portions of loans for lenders to make the loans cheaper for borrowers, which are small businesses that meet specific characteristics.

Some of these requirements are that your small business has sought other financing options, that the owner that is applying has a serious stake in the business, that you are a for-profit business, and that you use the loan for certain types of expenses.

The advantage of SBA loans is that they can be used for a variety of things. If you are going to be making any large real estate purchases, have any upcoming construction projects, are making any large capital or facility purchases, need a line of credit for working capital reasons, or expanding export capacity, you can get an SBA loan to provide you with a lump sum of cash.

The terms of an SBA loan are usually pretty favorable. Programs like the SBA 7(a) loan program provide reduced interest rates and restrictions on prepayment penalties. Borrowers love SBA loans, but they can be hard to get. You do have to be in business for some time and show that you have not tried other lenders first.

Banks and other lenders give you SBA loans. The SBA covers a part of the loan as a guarantee for the bank, making the loans more affordable for banks and financial institutions to give.

Bank Loans

Bank loans are just like they sound. Banks, as well as credit unions, offer businesses a variety of loans. However, these loans are not that convenient.

Bank loans can be used for a variety of purposes, including real estate, construction, equipment, line of credit, or other similar financial needs. Bank loans can have long terms on the loans, which can be helpful to your small business by giving your small business time to pay the bank back. Additionally, you can sometimes get really low-interest rates and favorable terms on bank loans for your small businesses.

Bank loans, however, can be a cumbersome process. Your small business will need to have a good credit history to be able to get a bank loan. The bank will almost certainly pull your small business credit report and scrutinize potential risks. Business term loans will likely also look into your small business’s financial statements, your business plan, and more documents to reflect the profitability of your business and its likelihood of correctly managing the debt that your small business is taking on.

Line of Credit

Lines of credit can be a helpful tool for your small business. If you are trying to maintain or improve the cash flow level of your business, you can utilize a line of credit. A line of credit is a unique type of loan. It may appear similar to a credit card style of loan.

When your small business is given a line of credit, you are given a maximum credit limit from which your line of credit can draw down on. This means you are guaranteed an amount that you can borrow from a lender as you go along with your small business affairs. If your small business runs into problems with unexpected expenses, you can draw down the line of credit.

Usually, the amount of money that you draw down on the line of credit is the debt that you pay interest on. Also, lines of credit are typically revolving. This means that as you pay back the amount of money that you owe, you can re-borrow that money on the line of credit later.

The exact amount of interest is usually dependent on the market, as these loans typically have variable interest rates. Lines of credit can also be loaned by both banks and online lenders (like Biz2Credit!). The interest rates and terms on these loans will differ. Typically, a bank will offer lower interest rates and longer terms, but these lines of credit will come with a lot more documentation, a longer application process, and higher requirements for your business. These lines of credit might take longer to get.

Alternative lenders, on the other hand, can usually offer your small business quick access to a line of credit. There is less documentation involved, the process is shorter, and there is less due diligence on your business. To compensate the lender for the added risk and less due diligence, the interest rate may be slightly higher, and the term might be slightly shorter. But there is no need to worry, as for many, alternative lenders can be a great option. This is especially true if you have a history of bad credit or if your business credit score does not show a very long history of good credit.

Short-Term Loans

Short-term loans are a unique kind of loan for your small business. You may need to access a lot of capital quickly for your small business. This might be very important if your small business is experiencing a large unknown expense affecting the operation of your business. For example, if you are running a small trucking business, one of your trucks might have a major part break that needs to be replaced quickly.

Such is the logic for turning to a short-term small business loan. These types of loans can be processed in as little as a day. The way these loans work is that they typically have a repayment period ranging from three months to two years. Rather than paying interest on the loan, these loans usually carry a fee. That way, as a small business owner, you know what you are getting yourself into in terms of costs right away.

These types of loans can be expensive. However, they might be the right choice for your business so that your business can continue generating revenue even if you experience a minor problem. Waiting to input capital can sometimes take too long.

Medium-Term Loans

Unlike short-term loans, medium-term loans operate on a different set of terms and for a different set of purposes for your small business. These might be for expenses that you would pay for over a series of years. The terms on these kinds of loans are usually between three to five years. This can allow your small business some flexibility to pay down the debt as you generate cash flow.

The interest rates on these loans can be lower. Many online lenders offer these medium-term loans, which are usually shorter than a bank loan. Some history of your business will need to be established, however. Your business should not be brand new for this kind of loan. You will need to show that your business can generate money and stay in business for some time. This could be one or more years, for example.

Equipment Financing

Equipment financing, or equipment loans, are small business loans used to purchase equipment. Equipment is extremely relevant in the operation of many small businesses. This is because equipment or machinery is used very often in the production of a good. From small businesses in the food industry to small businesses doing manufacturing, agriculture, or other various economic activities, equipment is often widely used.

Equipment, while widely used, is also expensive. Many small businesses do not have the level of cash flow to be able to fund a one-time, all-upfront purchase of equipment. Some small businesses might prefer a loan where they can make an initial down payment and make monthly payments on the remaining balance. Spreading the cost out over time can make an equipment purchase much more affordable for a small business.

Lenders also love equipment financing. Interest rates for equipment financing are often very low. This is because the equipment that the small business purchases with the loan is used as collateral. If the borrower ends up defaulting, the lender can take the equipment as collateral and essentially insure themselves against losing money.

Within equipment financing are many different types of equipment loans or leases. You can read through each type to decide which is best for your small business situation.

One of the first options for your small business is called lease financing. Lease financing is a leasing mechanism whereby a small business leases a piece of equipment for a specified period. The small business then pays a lease payment each month. Once the lease is up, the small business has the choice between continuing the lease, returning the equipment to the firm leasing the equipment, or purchasing the equipment outright. As you might be able to see, this option gives small businesses increased flexibility while also reducing the upfront costs to small business owners.

The second option is known as a capital lease. A capital lease is similar to lease financing in that you make lease payments on the equipment you are leasing for your small business. However, once the lease is up, your small business will definitively own the equipment. This is a great option if you are sure that your small business will want to keep the equipment that you are using, and you do not want to have to deal with the hassle of getting a new piece of equipment in its place.

The third option for equipment financing is called an operating lease. An operating lease is a lease where you make payments for leasing the equipment from a firm that leases it, and at the end of the leasing period, you return the equipment to the firm that is leasing it. This can be a great option for your small business if you are sure that you always want to have newer equipment on hand. If you want to have the setup automatically built in where the leasing company is prepared to replace the equipment with a new operating lease once your operating lease ends, operating leases might be for you.

Personal Loans

Personal loans are similar to what they sound like. While personal loans can be used for a variety of small business purposes, their availability will depend on your situation, connections, and relationships.

Personal loans are usually used for smaller business expenses when starting up. The loan is usually given out of trust that you, as a small business owner, will pay back the loan to the lender. The lender may be a family member or friend. They might offer you a favorable interest rate, too. However, these loans may not be a great option past starting up your business. This is because these loans carry the risk of damaging personal relationships if you end up defaulting.

While your small business might be successful, it is always important to consider the risk of default. Managing your business well is always a great defense mechanism against this, but sometimes, unforeseen circumstances like the fallout of the COVID-19 pandemic can cause some businesses to default on their loans by missing their monthly payments or going out of business.

In any case, if you are considering exploring personal loans, you might select this option if you are just starting out or if you are unable to access other sources of loans, like online lenders.

The Small Business Loan Application Process

While there are a variety of small business loan types available to your small business, the small business loan application process can also prove to be confusing. Navigating your small business to the right loan and lender is important. However, it is also important to lead your business through the small business loan application process efficiently and effectively so that you can get the funding you need quickly and so that you do not waste precious time.

To prepare your small business for the small business loan application process, it is best to read through the steps of the process and plan your responses accordingly. This can help make your management of getting a small business loan much clearer and more effective.

Determining the Loan which is Right for Your Small Business

As mentioned in this post, determining the right loan is important for your small business. It starts by assessing what the potential use case is of the capital you intend on getting from a loan.

Of course, this is an important first step before seeking a loan. You will want to make sure that any time you go to get a loan, you have a well-reasoned plan for the capital. By taking out a loan, you will be paying interest on the new debt. This represents an additional cost to your business. Theoretically, this is only a good expense if you expect to have a better use for your current cash flow or if not taking out the loan would make your operations less profitable.

Once you have the reason for the loan established and you are confident in the financial reasons for doing so, you should begin to select the loan. Important characteristics for the loan might be whether you need more of a line of credit or a loan for a very specific, singular purpose. If the latter is true, it might be helpful to think of the length of the loan that you need. You should also consider the conditions of a loan that are important to you. These might include things like the speed of the loan processing or whether there are prepayment penalties or certain covenants.

Prequalifying on the Loan Application

Once you have determined the type of small business loan that your small business is interested in, it is time to start shopping around for lenders. You can do this by searching online for your ideal loan and locating the type of firm you are looking to lend from. This might be banks, credit unions, or other alternative lenders.

Once you have arrived at the website of the lender, locate the loan application you are looking for. At this time, you will have to enter some information to get estimates of the amount of a loan you qualify for, your likely interest rate, and the relevant terms. Getting this early estimate allows you to then be confident in shopping around for that commercial real estate, equipment, or construction project that your small business needs. You know that you have a lender able to back up the order you put in to purchase something.

This process is known as achieving prequalification on a loan. Usually, prequalification means that your small business loan lender will let you know what you are likely to qualify for. This is based on the information that you volunteer in an application.

The information that they ask you for will likely include the purpose of your loan, information about you, details about your business, and key financial metrics of your small business. This information will allow the lender a basis from which they can estimate the financial capabilities of your small business to repay a loan.

Verification and Loan Underwriting

After you have this prequalification information, and after you are ready to purchase something for your small business with your small business loan, it is time to enter the verification and loan underwriting process. Essentially, this means that you and your small business will need to have the veracity of the information that you provided on your application assessed.

This is done by the lender requesting a host of documents, which include documents related to your identification, your credit history and the credit history of your small business, the bank and credit card statements of your small business, and many financial statements of your small business.

These documents help to verify the information that you declared in the prequalification stage. This is the verification process. The underwriting process is where the lender then uses this information to give you a final offer. They will write up a contract for you and your small business to accept. The lender will present this document to you with the final details of your loan. You should check these details and be certain that you are okay with the conditions of the loan, as the terms and conditions of the loan may have changed since you made an initial offer at the prequalification stage.

Funding

Once you have signed your lending offer, the loan is yours. The transfer to your small business bank account can happen as soon as one day. You should coordinate with your lender to understand what details you can provide them with so that your small business can receive the funding it needs as quickly as possible.

What Lenders will Look for in Your Small Business

As you get ready to apply for your small business loan, it may benefit you to consider what lenders will look for in your small business loan application. Largely, these will be empirical details about the performance and history of you and your small business. The lender wants to get to know whom they are lending to be secure and confident that lending to your small business will be an appropriate deployment of their capital.

If you can understand the need for clear and transparent information, and you can take steps to provide them with the information they need in an appropriate and speedy format, you can increase the chances that the lender will be optimistic about accepting your application. Since many of these details can be hard to change on short notice for the loan, since they are largely about the performance and history of your small business, these are better to just understand and supply clearly to your lender.

Credit Score

Your personal credit score and business credit score may be factored into your lender’s decision-making. This is due to the lender needing to be sure that their capital will be paid back. If you have a bad credit history, then this could turn potential lenders away. In any case, your credit score will likely be a major factor in your lender’s decision-making.

Revenue

Revenue is an important metric for lenders. Since your small business is trying to get a loan, your annual revenue will play a role in their decision. This is because they want to make sure that your revenue will provide enough room for you to pay back the loan. If your business has been struggling to bring in revenue, then the loan becomes riskier for the lender.

Collateral

Business financing and loans may also take an interest in the collateral. Especially for larger loans on real estate, equipment, or other big purchases, the availability of collateral will influence the decision to grant your small business a loan. Collateral de-risks the loan for the lender, as the lender can be sure that they can recover some of the value of the loan if you default. Without collateral available in the loan, you may be offered higher interest rates or denied a loan. This will depend on the loan type, however.

Time in Business

Time in business is another large decision-making factor for lenders. The time in business is defined just as it sounds. Lenders are interested in knowing how long you have stayed in business. They want to be sure that your small business will continue to stay in business and generate revenue to pay back the loan amount that you are given. They can use this information to project the likelihood that your business will continue to exist.

Required Documents

As previously mentioned, providing the required documents will be a task that lenders expect. This will include your personal information, business information, such as bank statements, and other documents to confirm the eligibility of your business. Small business financing necessitates that you are upfront with your documentation in your business so that you can be sure you will be qualifying with the lender seeking to verify your business information.

Key Takeaways

Loans are often an essential resource for small businesses. They can be the gateway to growth and expansion, the stopgap to fill a cashflow shortage while you wait for accounts receivable to be paid, and so many other things. As a result, it is incredibly important for small business owners to understand how small business loans work and what options are available to them based on their individual circumstances and credit history. You never know when an opportunity or crisis may arise that requires you to act fast and acquire a loan. Knowing the steps in advance and what will be required of you and your business can make an enormous difference.

As with any aspect of running a business, the key to success is staying diligent and doing your research. Before taking out any loan, you want to make sure you fully understand exactly what you are agreeing to and what the terms and conditions are. Once you understand these, you can make sure the loan actually makes sense for your business and will fit well into the operational budget. Loans should only be used when they make sense – not just for the sake of it. It can often help to have a lawyer take a look at your loan contract in advance so that they can explain all the terms and conditions to you. That way, you can be confident you have all the information you need in advance of signing the dotted line.

All-in-all, understanding how small business loans work is a vital part of running a company. Loans are ubiquitous in business and used for a wide variety of purposes and objectives. While this post only scratches the surface of small business loans, how they work, and what is available to you, it can serve as a great launching pad. So, start researching and learning more! A small business loan could end up being just what your business needs in the very near future!

Biz2Credit

At Biz2Credit, we pride ourselves on our commitment and dedication to providing small businesses across the nation with the tools and resources they need to succeed. As part of this, we run out Biz2Credit Blog, where we keep tabs on all the latest news, information, and trends impacting small businesses and their operations. We post new content each weekday for our readers. So, please continue to check back here for all the latest articles on everything small business related!

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