Whether you want to start a new business or grow your current organization, loans can help give you the business capital you need to make it happen.
Learn more about the different kinds of loans, what you need to apply for one, and how they can make an impact on your company.
How do business loans work?
Much like a personal loan, a business loan is a sum of money that a lender (usually a bank) loans to a business with the understanding that the business owners will pay back the amount borrowed plus interest.
You will have to apply for the loan and receive approval, and the lender will determine your interest rate in advance. The amount you can borrow depends on many factors, including the size and financial health of your business. The repayment schedule could be over the course of months or years, as agreed upon by the lenders and borrowers.
What are business loans used for?
Business borrowing can have many different purposes, such as:
Starting a business
Unless you are bootstrapping your organization, you’ll likely need a loan or line of credit to get started. The amount you qualify for will largely depend on your personal financial situation.
Increasing cash flow
You may need an infusion of capital to get you through a low season, or you may want to invest in new stock. Whatever your requirements are, a loan can help increase your cash flow.
Buying assets or property
Whether you’re replacing outdated equipment or making a one-time property purchase, you may need small business lending to help you afford the cost.
Large, long term projects, such as an expansion or new product line, may require more cash than you have on hand—but if you believe they will pay off in the long run, a loan can help you make ends meet in the meantime.
Questions to consider before choosing a business loan
In order to find the right loan for your situation, start by asking yourself the following questions:
How much money do you need?
Take the time to add up all of the costs of your new venture. Though it would be nice to just request a loan for as much money as possible, it’s a better idea to know exactly what you need.
What is the money for?
Lenders will want to know where you intend to spend the new funds. If your business plan is strong, you’ll be able to explain why it’s a sound investment.
How long will it take for you to pay back the loan?
This is the tricky part. Lenders need their money back, plus interest, in a timely manner. Make sure you understand how long it will take for you to pay off the loan and discuss the timeline with your lender.
Do you need a short- or long-term loan?
Short-term loans can put money in your hands quickly, but you often need to pay them back in a short amount of time, and they can have higher interest rates. Business term loans, business lines of credit, and invoice factoring are all considered short-term business loans.
Long-term loans are different, because you can usually pay them back over the course of multiple years. They tend to have lower interest rates, but keep in mind that you’ll likely pay that interest over a longer period of time, so the amount can add up.
Types of lenders
The three main types of lenders for small to medium businesses are banks, online lenders, and nonprofit microlenders.
Banks can be your first stop if you have been in business for two or more years and you have good credit. It may take some time to get the cash in your account after you apply, but banks are usually the lowest APR option you’ll find, so it might be worth the wait.
Online lenders are a good choice for relatively new businesses who don’t have any collateral and need funds fast. The APR can vary widely depending on the lender you choose, so be sure to do a little research before selecting a company.
Nonprofit microlenders are appealing for new businesses with bad credit (or no credit) that need less than $50,000. Keep in mind that the APR can be a lot higher than traditional bank loans.
How to apply for a business loan
Before you apply for a loan, there are several pieces of information you’ll need to gather so the lender can make an informed decision about loaning you money. If you have an existing company, your business loan requirements usually include:
- Personal and business tax returns
- Personal and business credit scores
- Credit reports
- Financial documents, including your balance sheet, income statements, and cash flow statements
- Collateral documentation
- Your business’s legal documents
Taken together, these items can paint a picture of your business’s financial health, so that lenders can be sure you’ll pay back the loan.
If you’re starting a brand new business, make sure you have:
- Your personal tax returns, credit score, and credit report
- Bank statements and proof of income
- A plan for your future business
This kind of information can help show lenders that you are financially responsible and will make sound business decisions.
When you apply for a loan, it’s a good idea to start with your existing bank to see what your options are. If you’ve been with them for several years, they may offer you loyalty terms that are more competitive than other options. Be sure to compare their loan rates with other options so you get the best offer available.
What are the types of small business loans?
Business loans differ in length of term, interest rates, payment deferment, and eligibility criteria. Choosing the right type of financing can launch your business into unprecedented success, while choosing the wrong loan can leave you feeling trapped by challenging repayment terms or inadequate funding.
Check out the chart below for a quick overview of common business loan rates and other important details.
Term loans are traditional bank loans, and they are very straightforward: a set amount of money, paid back with interest on a payment schedule. Term loans are available through banks or online lending platforms. Banks are generally going to offer better terms, but may take a little longer to get your capital. Online lenders can provide rapid funding, but may charge higher interest and give shorter loan term lengths.
Term loans are best for businesses that need ongoing capital, whether for improvements, expansion, or acquiring a new business.
Term loan requirements
Depending on your bank, you may need to meet certain criteria for the age of your business. Online lenders usually require 1–2 years in business. Your business credit score will be factored in to determine how much you may qualify to borrow and the interest rate assigned to your loan.
Business line of credit
A business line of credit gives your organization access to a sum of money that you can draw whenever needed. You can get a fixed line of credit, or a revolving line. Fixed lines are a set amount that is used and paid back once, while revolving lines of credit reset when the balances are paid (like a credit card).
Business lines of credit are best for short term needs and emergencies, such as a revenue drought, accident recovery, or other unforeseen circumstance. However, revolving lines of credit can also be useful as a backup source of funding that you can access when you’ve exhausted your typical cash flow.
Business line of credit requirements
You don’t need to be in business as long to get a line of credit as you might for a term loan, but you may need at least a few months of operation before qualifying. Your credit score will also determine credit limits and interest terms.
The Small Business Administration provides guarantees for loans to assist American small businesses, essentially encouraging banks to give favorable loans with longer terms. These are generally the most affordable loans after traditional bank loans, and there are a few different options offered by the SBA to meet your needs.
The standard SBA 7(a) and 7(c) loans can allow companies to expand or acquire new businesses or equipment. SBA Disaster loans can be used for physical and economic disasters. Learn more about different kinds of emergency loans.
The recent Paycheck Protection Program created by the CARES Act has been an incredibly popular choice of SBA loan for small businesses responding to COVID-19 complications. Learn more about the Paycheck Protection Program.
These are the most common types of SBA loans:
- SBA 7(a) loans, including:
- Standard 7(a) loans
- SBA Express loans
- Community Advantage loans
- Veterans Advantage loans
- Export Express & Export Working Capital Loans
- SBA CAPLines of Credit
- SBA CDC/504 loans
- SBA microloans
Visit SBA.gov to learn about each loan type in more detail. In general, SBA loans are best for long-term loans for healthy businesses.
SBA loan requirements
The Small Business Administration has high standards for their loans. You must have a good credit history and strong profits to qualify for an SBA loan. You will likely need to show that you’ve been in business at least a year to qualify for most SBA loans.
Purchasing new equipment can be an expensive but important step for small businesses. Many small business owners look for loans specifically designed to help them purchase new tools, machinery, vehicles, or other necessary equipment to grow the business.
Equipment financing requirements
Most business owners can qualify for equipment financing, even if they have lower credit scores, because the equipment you purchase also functions as collateral. Often you will just need to provide documentation of your business plan and explain the reason for the equipment purchase (in addition to your credit score). Some finance options may require a certain annual revenue requirement.
Some businesses face financial challenges when they are waiting for customers to pay outstanding invoices. Invoice financing can bridge the gap in cash flow by giving you a loan for 80–90% of the invoice amount, and usually charging a weekly fee until your customers fulfill their invoices.
Invoice financing is best for businesses facing temporary cash flow problems due to a large volume of unpaid invoices or a large amount of outstanding accounts receivable.
Invoice financing requirements
Invoice financing may require a certain age of business, annual revenue, and usually a credit score above 500 for eligibility. However, invoice financing can be easier to secure than traditional small businesses loans because the invoices serve as collateral.
Commercial real estate loans
Commercial real estate loans are used to acquire commercial property such as land, a building for a storefront, or a facility for manufacturing or operations. Commercial real estate loans are structured differently than conventional loans, and may require a significant downpayment. Commercial real estate loans may be “balloon loans,” where smaller installments are made and then a large lump or “balloon” payment at the conclusion of the loan term.
Commercial real estate loans are best for financing commercial property purchases—like a retail shop, office, or facility.
Commercial real estate loan requirements
Businesses may need to provide the gap between the loan and eventual value of the property (Loan-to-Value) as the down payment for the commercial real estate loan.
Does your business need just a little bit of working capital to reach your next goal? Microloans are designed for smaller, newer businesses that need less than $50,000 for startup, expansion, or fast working capital. Nonprofit lenders, such as Kiva and Accion, and the SBA Microloan program provide microloans as a way to support new business and to strengthen communities in need.
Microloans are best for businesses needing small sums, or for micro-businesses like food trucks, freelancers, startups, and entrepreneurs with new businesses.
Targeted microloans are available for women, minorities, veterans, and other groups. You may need to be located in a certain area, and you may need to provide collateral for the loan. However, eligibility for these loans is more relaxed due to the smaller total sum.
Merchant cash advance
A merchant cash advance is a very expensive loan option funded through a merchant account that takes a percentage of your daily credit and debit sales after providing you a cash advance. The interest can be punishing, but repayment stays low if your sales are low. Merchant cash advances can be a good last resort when you need fast cash, especially if you have the cash flow to repay it.
Merchant cash advances are best for businesses that don’t qualify for other types of loans.
Merchant cash advance requirements
Merchant cash advances rely on sales for repayment, so usually proof of gross revenue or monthly card sales is required.
Personal loans for business use
For small businesses, a personal loan may be a funding option for your company. Owners with great credit scores can get personal loans with favorable terms that they can use to fund a startup or support their growth. Personal loans can also be used in combination with other types of loans to reach a particular financial goal.
Personal loans are best for small business owners with excellent credit who need a smaller loan.
Personal loan requirements
A good or excellent credit score (625 or greater) is critical for getting a personal loan that will be beneficial to your business.
Secured vs. unsecured business loans
All loans fall under the category of secured or unsecured, and the difference is pretty easy to understand.
Secured business loans require you or your business to put something up for collateral before receiving the funds. The collateral is something that the lender could take away if the business doesn’t pay the lender back in a timely manner. For example, if you take out a loan for $250,000, you might put up your home as collateral.
Unsecured business loans do not require any collateral. These loans can be harder to qualify for than secured loans, because the lender has fewer options if you don’t pay back the loan on time.
How does business loan repayment work
There are three main types of business loan repayment options: revolving, installment, and cash flow.
Instead of a set repayment term, this unconventional loan is paid back with incoming business cash flow. Because these loans typically come with higher risk for the lender, they also typically come with higher interest rates.
Business lines of credit and business credit cards typically have a revolving repayment plan. This means that drawing from your line of credit reduces your available credit, while repaying the amount raises your available credit back to the original amount. This is similar to the way a personal credit card works.
This plan will have a set repayment schedule, usually in monthly installments, that are the same amount every pay period until the principal and the interest are fully paid off.
The right choice is always obvious
This guide is a great place to start when researching loan options, but remember that your company’s finances may need customized recommendations to stay on the right track. Be sure to talk to your financial advisor about the right types of loans for your business and personal circumstances.
Want more business credit options? Schedule a demo today to see how Divvy can help you finance your organization.
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