How do small business loans work?
In this guide, we go over the different types of small business loans and take an in-depth look at how they work.
In this guide, we go over the different types of small business loans and take an in-depth look at how they work.
In a typical small business loan, a lender gives the business owner some money upon request. The business owner must then repay the loan, usually with regular payments, over a predetermined period, with interest. In its most basic structure, the interest of a small business loan will be a percentage of the loan principal.
Loans are necessary in business for many reasons. Whether it’s upfront cash for getting the company up and running, attracting and paying talented employees, or expanding operations, every business requires quite a bit of money. That’s what makes small business loans invaluable.
In this guide, we define small business loans and take an in-depth look at how they work. So, let’s get right to it.
A small business loan is a sum of money that a small business owner borrows to either start, run or expand their business. The money is usually repaid over a predetermined time, typically with regular payments, and with interest.
Small business loans are not entirely different from personal loans (which you’re probably already familiar with). In fact, the biggest difference is the recipient. While a small business loan is made out to your company, a personal loan is made out to you personally.
Small business loans fall under the category of debt financing. They offer a great opportunity for entrepreneurs to access money for various business needs. Such needs include working capital, business purchases and acquisitions, attracting and paying talented employees, expanding operations (like opening a new branch) etc.
Over time, these varying business needs have incentivized small business lenders to create loan options for different purposes. The next section looks at small business loan options that are available for entrepreneurs.
There are several types of small business loans available, each with its set of features and requirements. Your business’s financial health, revenue, credit score, and collateral will play a role in determining the type of small business loan that you can qualify for. Here’s a lowdown on options that you can explore.
Term loans are traditional bank loans. When a lender approves your application for a term loan, they give you a lump sum of money that you have to repay with interest over a pre-specified period. Term loans typically take fairly long to repay – five or more years. You will, however, need to make regular repayments. These can be monthly, bi-weekly, or even weekly. It all depends on the terms of the loan.
Generally, small business term loans provide large amounts of money, ranging from $5,000 all through $500,000. For this reason, term loans are ideal for high-value investments like purchasing a business equipment or opening a new branch.
The downside of term loans is that they tie your business to a long-term repayment schedule, which may affect your cash flow. Plus, they follow the same amortization schedule as regular mortgages and car loans. This means that most of your initial payments will go towards paying interest. Considering their duration, term loans can be quite costly because of accumulated interest.
On the upside, they do provide an amount that can hugely boost your capital. Additionally, most term loans carry low interest rates – as low as 2.5%. This translates to potentially low monthly payments.
Short-term loans are essentially term loans, but with a shorter repayment period. Your business receives a lump sum of cash that you have to pay back with interest, typically in under five years. Apart from the repayment period, the biggest difference between short-term and term loans is the amount. While term loans offer a large value, short-term small business loans come in smaller amounts of between $2,500 and $250,000.
They also carry higher interest rates than term loans. Very rarely will you get a rate of under 10% with a short-term business loan. This higher rate and shorter repayment period often translate to high monthly payments. At times you may need to make payments on a weekly basis, which can really strain your cash flow.
The advantage of short-term loans is that they present a short-term debt obligation. You can finish paying off the loan in a year or two, and focus on other investment projects. For this reason, short-term loans are generally ideal for short- and medium-term cash needs. For example, you can use this type of loan to cover temporary cash flow gaps caused by the coronavirus pandemic.
While most small business loans are meant for making investments and purchasing assets, working capital loans are intended to finance the daily operations of a business. These may include payroll, rent, and debt payments.
Although they are funded in lump sum, small business working capital loans have smaller amounts and shorter terms, usually between 3 to 12 months. You can get anywhere from $5,000 all through $500,000 – but mostly the amount will be closer to $5,000. This makes them ideal when you need short-term financing for running your company’s daily activities. Plus, their short term means that you won’t be stuck with a long-term repayment schedule.
On the other hand, most lenders will tie your business’s loan to your personal credit. Thus, if you fail to make your payments, your personal credit score may be negatively affected. This is a factor worth keeping in mind because most small business working capital loans carry an interest rate of between 11 and 16% - which can make monthly payments high.
These are loans that are backed by the Small Business Administration (SBA). The SBA doesn’t originate loans. Instead, it guarantees them, allowing private lenders like banks and unions to generate them at a low risk.
The administration guarantees up to 85% of amounts that top out at $150,000 and 75% of larger amounts. What this means is that if you’re unable to repay the loan, the SBA will pay the lender up to the amount guaranteed. Because of this security, lenders often offer low interest rates (as low as 6.5%) and long repayment periods of up to 25 years.
However, the SBA sets pretty stringent guidelines for eligibility. That, coupled with the competitive nature of SBA loans, makes them hard to qualify for. For example, every borrower now needs to put a mandatory 10% down payment. Most lenders will also require that you have a personal FICO score of at least 720 and SBSS score of 140 or more.
The maximum amount you can get with an SBA loan is $5 million. Very rarely do businesses get approved for the maximum. Oftentimes you’ll get around $500,000..
A business credit card is a credit card that you strictly use for business expenses rather than personal expenses. It works in the same way as a personal credit card, except you get a higher limit with a business credit card.
Besides, some small business credit card companies will report your business activity to your consumer and credit bureaus. This means that if you default on payments, both your personal and business credit scores may be affected. That’s something to keep in mind when considering applying for a business credit card.
Having said, business credit cards make a lot of sense if you want to save on the cost of credit. This is especially the case if you get a 0% APR introductory period. During this time, which can last up to 12 months, the lender won’t charge interest on any purchases you make. The card, therefore, gives you access to interest-free credit purchases.
Small business credit card limits vary greatly from one lender to another. However, most will cap it at $100,000. Of course, any amount you pay on the remaining balance goes into your available balance and you can borrow it again. For this reason, a business credit card is a revolving fund.
A small business line of credit works in the same way as a credit card. The lender gives you a fund that you can access whenever your business needs cash. When your billing cycle comes around (usually monthly), you pay some of the used money, and the lender puts it back in your fund and you can borrow it again.
This borrowing and repaying cycle makes a business line of credit a revolving fund. And that means you can withdraw and repay the money as long as your draw period is active and provided you don’t exceed the set limit. A business line of credit can have a long period of up to five years. Each lender will set their credit line limit based on your company’s financial health. However, you can generally expect a limit of anywhere between $5,000 and 1 million.
The biggest advantage of a business line of credit is that it avails money quickly. Because of that, it’s ideal for emergency financial needs. If, for example, you need to boost your cash flow, you can tap into a credit line and withdraw some cash. The tradeoff is that business lines of credit carry high interest rates. Most will start from 10% APR and may go all the way to 30%+. However, you only pay interest on the amount you use. It’s not like a loan where you pay interest whether you use it or not.
Equipment loan is when your business takes out a loan specifically to buy new equipment or replace existing equipment. If, for example, you own a restaurant, at some point you may need to replace your commercial convection oven. Should you lack the money to do so, you can turn to a lender for an equipment financing loan.
This type of loan is known as a self-secured loan, which means that the equipment you buy acts as security/collateral for the loan. For this reason, it’s typically easy to get your hands on 100% financing for the equipment you’re trying to buy. However, some lenders may ask that you put a down payment to minimize their risk further. That’s not always a bad idea because typically the more the down payment, the lower the interest rate.
Equipment loan interest rates vary widely and may range from 2% to 20%. As far as the term of the loan, oftentimes the lender will set a period based on the projected life of the equipment.
Also known as accounts receivable financing or factoring, invoice financing is when you sell your receivables (outstanding invoices) to a lender. They then give you funds that your business can use. When your debtors pay, the money will go straight to the lender.
Invoice financing is great when you want early payment for your invoices. This may be the case if your business is strapped for cash and debtors are just not paying on time. Your lender will take the risk of your invoices in exchange for instant cash to your business. The invoices act as collateral, making it a self-secured type of loan.
Keep in mind that lenders don’t pay the full amount on the invoice. Instead, they’ll loan you up to 90% of the total worth of the invoices. The 10% remains in reserve and is held by the invoice factoring company. It will eventually be disbursed to you (less applicable fees) once your debtors pay their invoices in full.
Since invoice financing is self-secured, you’ll often get low rates and great terms. Typical charges include a 3% origination fee and an additional 1% factor fee every week that your invoices go unpaid. These amounts are charged on the principal.
As the name suggests, a startup business loan is capital that you borrow to set up a new business. The money goes towards things like working capital, buying inventory, purchase of equipment, acquisition of machinery, getting furniture etc. Depending on the amount, you can even use a startup loan to buy or rent premises for your small business.
A startup business loan is an excellent alternative to the other types of business loans. In fact, most of them will be out of reach for you if your company is completely new. This is what makes startup loans invaluable to entrepreneurs – they avail cash even before you make your first sale. However, you’ll need a strong business plan and personal creditworthiness to qualify since the lender won’t be looking at business revenue or business credit when processing your loan application.
Interest rates for startup business loans typically range from 10% to 30%. They’re not the most expensive loans for borrowers, but the rates are higher than, say, traditional loans. The amount and repayment period largely depend on your personal qualifications as well as terms of the lender.
Besides traditional banks, you can also get small business loans from online lenders and peer-to-peer sites. Below are your options when shopping around for a small business loan.
As a borrower, when you think of getting a business loan, perhaps the first thing that comes to mind is a large commercial bank. Banks do have their advantages. They generally offer larger loan amounts than other lenders, which makes them great when you need to expand your business or acquire a costly asset.
Besides, commercial banks can lock you in at a low interest rate. This often happens when your credit score is excellent and your business revenue is enough to guarantee repayment of the loan. However, banks have stringent qualification requirements. Most of them will tie your personal and credit scores, which (in the long run) may negatively affect your personal credit.
The biggest advantage of community banks over commercial banks is that they offer more personalized services. They are locally owned and operated, making them ideal for a borrower who is looking for community-based support. They do make reliable financial partners for growing your business.
Another benefit of community banks is that they have less stringent qualification requirements compared to commercial banks. For example, rather than just looking at your credit score, most of them consider other aspects of your credit history as well. This is great if your credit history is good but your score is not that decent.
On the flipside, their smaller size often means that community banks will have fewer financial products to choose from. You may also find that they have limited technology, which can be inconveniencing. If you can’t get services like mobile banking, then you might be missing out on a lot.
A neobank is a banking service that operates entirely online without physical locations or branches. They are essentially digital banks that specialize in one or few financial services. For example, you can find a neobank that offers a spending account but doesn’t have investment options or certificates of deposit.
Neo banks and digital lenders use technology to streamline financial services. Since they don’t have physical infrastructure, their operating costs are usually low. Oftentimes they’ll pass these cost-saving benefits to their customers.
Nearside is a great example. With a Nearside business checking account, you don’t pay NSF fees or account maintenance fees. You don’t even need to have a minimum deposit amount. Such accounts are perfect for small businesses that are keen on saving costs.
Just as important, neobanks and online lenders tend to have less stringent qualification criteria for their loans. Their processing time is short, too. This makes them ideal if you’re shopping for a quick loan and don’t qualify for traditional business loan options.
The Small Business Administration (SBA) doesn’t issue loans, it guarantees them so that private lenders can originate them with minimal risk. The administration works with designated lenders who issue SBA loans. These are the banks to visit when you’re considering SBA loans.
It’s worth mentioning that SBA loans are very competitive and difficult to qualify for. Lenders typically look at your credit score, revenue, down payment etc. However, they are well worth your consideration because they come with low interest rates and longer repayment terms.
Peer-to-peer (P2P) lending sites act as intermediaries between the borrower and investors. They match you (the borrower) with investors who are willing to lend their money to you. You’ll then pay it back with interest, some of which will go to the site. Some examples of peer-to-peer lending sites are Prosper, Upstart, and Peerform.
The biggest benefit of P2P sites is that their loans are easier to qualify for. Quite a few sites offer competitive interest rates as well, which makes their loans potentially affordable. However, a majority of P2P sites actually have higher interest rates than market rates. Therefore, consider the overall cost of credit before settling for a particular P2P site.
The best way to qualify for a small business loan is to understand lenders’ requirements. That will set you up for success because you’ll know how to make your business eligible. Here are steps that you can take to qualify your small business for loans.
This refers to both business and personal credit. Most small business lenders will look at your business credit and reference it with your personal credit. Such information tells them whether you’re a diligent creditor – whether you pay your debts, including car loans, credit cards and mortgages. The higher your credit scores, the more lenders will be willing to give you loans, and with good terms. That’s because a high score makes you less of a risk.
What’s a good credit score for small business loans? If your personal score is at least 700, then you’re a good creditor. Anything above 800 is excellent. Business PayDex scores range from 0 to 100. Any value between 50 and 79 is considered fair, while values between 80 and 100 are considered good.
If your personal and business credit scores are lower than you would like them to be, consider taking proactive measures that can improve the scores. Top on the list is paying your debts on time and keeping debt balances low.
As already mentioned, knowing and meeting lender requirements will increase your chances of qualifying for a small business loan. Such requirements include credit score, minimum annual revenue, down payment, debt-to-income (DTI) ratio, and time in business. Here’s a summary of the general requirements:
The above requirements are not written in stone, they are merely ballpark figures. Each lender will set their own particular requirements based on your business’s financial health. For example, you may find one bank that requires a FICO credit score of 640 for SBA loans and another one that prefers 700.
That said, bank term loans and SBA loans are generally the hardest to qualify for. Other options, especially online loans and business credit cards, are easily available for most small businesses, even if your company is new.
Your business plan describes in detail how you plan to use the money you’re borrowing. It essentially explains how the loan you’re applying for can help your business grow or become more profitable. In addition to detailing your type of business, industry and product line, remember to add the management team. Also include a detailed analysis of the market, a sales and marketing strategy, and financial projections.
Collateral is something that you pledge as security for the loan you’re applying for. Should you fail to repay the loan, the lender may seize the item. Self-secured loans like equipment and invoice financing loans don’t need collateral. However, others may – it all depends on the terms of the lender. All SBA loans require collateral of 10% down payment and a personal guarantee from the borrower (you).
A small business loan refers to money that a small business owner borrows to start, run or grow their business.
In a typical business loan, a lender gives the business owner some money upon request. The business owner must pay back the full amount, usually with regular repayments, and with interest over a predetermined period.
Short-term business loans last less than five years while term loans can last anywhere between five and ten years. Most SBA loans are limited to ten years but real estate or construction SBA loans take up to 25 years. Other short-term forms of credit – including business credit cards, lines of credit and working capital loans last under five years.
Once the lender gives your business a lump sum of money, you have to pay it back in installments – typically of one month each. The amount to repay goes into covering the principal amount borrowed as well as interest accrued. Therefore, your monthly installment is a function of the monthly principal and interest.