Capital is extremely valuable for business owners. It helps them stay afloat and expand operations. Some business owners can use personal funds and operating cash flow to cover expenses, but others may need a business loan to cover costs. Businesses use loans to cover expenses and fund investments. Loans expand a company’s capacity, but they come with risks. Small business owners may struggle to make payments and default on their loans. You can protect yourself from this risk by only borrowing what you need and extending the loan’s duration to minimize monthly payments. Lenders mitigate risk by establishing small business loan requirements. That way, a business owner who is extremely likely to default doesn’t get capital.
Businesses must qualify for a loan before receiving funds. Traditional lenders use these parameters to filter out risky borrowers. Some lenders will welcome riskier enterprises, but they’ll set higher interest rates. We’ll discuss how lenders assess applicants. Knowing how lenders think will help you secure a desirable business loan.
What Requirements and Qualifications Do You Need for a Business Loan?
Lenders won’t give business loans to anyone, but they publicize their criteria. So here’s what you should look for before applying.
1. Credit Score
Lenders want to know if you can manage the extra debt before giving you a loan. Most lenders look at your credit score to see if you can pay back the loan. Five factors contribute to your credit score, and they all involve your ability to handle debt:
- Payment history: 35%
- Amounts Owed: 30%
- Length of Credit History: 15%
- New Credit: 10%
- Credit Mix: 10%
Most traditional lenders will request your credit score. They will set credit score requirements for obtaining a loan. Most lenders will accept your loan application if you have a good credit score. FICO defines a good credit score as anything between 670 to 739. Here is the breakdown of the five personal credit score categories:
- Poor: 300-579
- Fair: 580-669
- Good: 670-739
- Very Good: 740-799
- Exceptional: 800-850
Lenders will also check your business credit scores. PAYDEX breaks business credit scores into three separate groups:
- Bad: 0-49
- Fair: 50-79
- Good: 80-100
A fair or good credit score gives you a better chance of qualifying for a loan than a bad credit score. It’s understandable for lenders to check your personal and business credit scores. They will reach out to the business credit bureaus — Experian, Equifax, and Dun Bradstreet — for your business credit report. Experian, Equifax, and TransUnion are the three major credit bureaus that handle personal credit reports. Personal and business credit scores reveal an applicant’s ability to pay debts on time. Some lenders will not ask for your credit score, but their loans will have substantially higher interest rates.
Payday loans are some of the most predatory loans in the industry. These lenders don’t ask about your credit score, but they’ll charge APR as high as 600%. Consider raising your credit score before approaching a lender. Adding a few points to your credit score can help you secure a lower interest rate, which can help you save thousands of dollars over the loan’s lifetime. In addition, you can pay off existing debts, use a credit builder loan, or pay every credit card debt before the due date.
2. Age of Business
Lenders feel more confident giving money to an experienced business owner. Business owners with decades of experience have adapted to many economic environments and made many decisions for their companies. Lenders will more happily give their money to this cohort than business owners who launched their startups a month ago. You can also demonstrate your experience as a businessperson if you ran another company or made significant decisions for another company. Lenders want to work with experienced business owners with established companies.
This parameter should not deter you if you are just getting started. Experience is the best teacher, and you will become a smarter business owner as you go. Some lenders will help you during the early stages of your journey and provide capital to business owners who are just getting started. Additional experience can help you secure a lower interest rate, but receiving a loan when starting out can put you in a better position for your next business loan.
3. Cash Flow and Income
Lenders will only give you a loan if they believe you can pay it back. Your company’s cash flow and income statements provide them with a snapshot of your company’s current financial health. If your company has generated reliable cash flow and income over several years, highlight that in your application. Lenders want to see consistency instead of one strong year to justify the loan.
Your cash flow and income will determine how much lenders give you. Taking out a loan increases your debt service coverage ratio (DSCR), making you a greater risk for lenders. This ratio helps lenders determine how much of your net operating income goes toward repaying debt. A lower number can help you qualify for a business loan, while a higher number increases the odds of defaulting on the loan. You can lower your DSCR by earning more money or refinancing debt to reduce monthly payments. These measures will increase the maximum loan amount you can receive.
4. Current Amount of Debt
Your income and debt impact your debt-to-income ratio. Lenders use your current debts to calculate this ratio. They then consider how the new loan will affect your debt-to-income ratio. We’ll use an example to demonstrate how lenders think about your income and debts.
Let’s say a business owner makes $10,000 per month as income. However, the business owner already has debt obligations of $6,000 per month. Their debt-to-income ratio is currently 60%. A loan with a $500/mo repayment raises the debt-to-income ratio to 65%. A higher ratio gives the business owner less room for error, creating more risk for the lender.
Most lenders set debt-to-income requirements for their loans. Having a debt-to-income ratio below 43% will help you qualify for more loans. You can either increase your income or pay off more debts to improve your ratio. Debt-to-income ratio is more useful when lenders assess your personal finances. The debt service coverage ratio (DSCR) is like the debt-to-income ratio, but it looks at a company’s net operating income and liabilities instead of your personal outlook.
5. Collateral
Secured loans require collateral to reduce the lender’s risk. Collateral is an asset that lenders can seize if you don’t pay back the loan. A common example of a loan with collateral is a mortgage. When you take out a mortgage, the house is the collateral. Banks can take ownership of your home if you don’t make monthly payments. Some business loans follow a similar structure with equipment, real estate, or other assets as collateral.
Secured loans have lower interest rates than unsecured ones, which makes them enticing for some business owners. If you’re worried about losing collateral, you should not take out the loan. However, you should take a closer look at your finances if this fear is present. It can indicate you are taking on too much debt and need to look at your business’s financials. Trimming superfluous business expenses can make a difference. You don’t have to worry about losing your assets as long as you pay on time. Borrowers can get smaller, more manageable loans to obtain funds while lowering the risk of losing collateral.
6. Business Plan
Business plans help lenders understand where their money is going. These plans indicate a company’s current market position and initiatives to gain additional market share. You may find some or all of the following on a business plan:
- Financial projections
- Competitive analyses
- Growth opportunities
- How the company will allocate the loan’s funds
- Quarterly and annual goals
Some lenders will require a business plan and review it before giving you a loan. Therefore, it’s a good idea to review your current business plan and update it to increase the odds of qualifying for a business loan. A business plan is a great resource to have, regardless of whether you apply for a small business loan or not.
7. Financial and Legal Documents
Lenders have different requirements regarding the necessary financial and legal documents for obtaining a loan. Typically, lenders that ask for more documents offer more attractive interest rates for borrowers. A lender may include some or all of the following as required documents:
- Bank account statements
- Accounts payable and receivable
- Personal and business tax returns
- Payroll history
- Balance sheet
- Business insurance plans
- Other financial statements
Check a lender’s requirements before submitting an application. After you gather the financial and legal documents for one lender, keep them organized. This approach makes these same documents easy to retrieve if you need to apply for another loan.
Small Business Loan Options to Explore
Wondering which type of business loan or financing method can help your company? Here are several financial products to consider.
Business Term Loans
Business term loans are a popular funding source for business owners. Borrowers receive a lump sum and make monthly payments toward the principal. Business owners can select a fixed-rate or variable-rate loan for their repayment terms. A fixed interest rate results in more predictable payments, while variable interest rates fluctuate based on the market. Variable rates are less predictable, but the APR starts off lower for variable-rate loans.
If you can’t get a loan for your business, you can opt for a personal loan instead. Borrowers can use personal loans for any purpose. For example, you can use those funds to start a new business or get more capital for your existing company. Personal loans also have choices for fixed and variable interest rates.
Business Lines of Credit
Business lines of credit are funding sources you can tap into at any time. They are like an extra reserve you can use to cover short-term expenses. You only pay interest on a business credit line when you borrow against the credit limit. This difference can help you save money if you go with this funding source instead of a business-term loan—however, business lines of credit feature variable interest rates that are usually higher than business-term loans. Not every business owner uses this type of financing, but business credit cards make sense for most business owners. These cards have a revolving line of credit and can help you with everyday purchases for your company. Each purchase builds up your payment history and can positively impact your credit score. A higher credit score helps you qualify for better business loans in the future.
Commercial Real Estate Loan
Brick-and-mortar businesses build up equity in real estate properties. This equity gets them closer to owning a valuable asset debt-free, but business owners can also tap into their equity for additional financing. A commercial real estate loan lets you borrow money and use your commercial property as collateral. Since you already have the property, lenders feel more comfortable providing these loans. Financial institutions may also give you a lower interest rate because the commercial property becomes collateral for the loan.
Lenders still have a credit score and revenue requirements for taking out this type of financing. However, some lenders may be more generous with these requirements since real estate is a more valuable asset to lenders than most business assets.
Equipment Financing
Some loans specifically cater to equipment purchases. Instead of paying a never-ending lease for your business assets, you can buy equipment outright and eventually remove the monthly expense item from your budget. Owning equipment gives you more control and financial cushioning than making lease payments. Since most lenders use equipment as collateral for these loans, you can even get a lower interest rate.
Working Capital Loan
A working capital loan helps business owners address immediate financial needs and operations. These funds can keep a business afloat during slower seasons, so they are in a better position during busy seasons. Working capital loans also have customized payment plans that can align with your company’s cash flow.
Invoice Factoring
Invoice factoring is one of the few ways to borrow money without putting yourself in debt. This financing strategy involves selling your unpaid invoices. You will receive a percentage of the invoice’s face value, and the invoice factoring company will collect invoice payments. Some companies handle all of the communication, so you don’t have to worry about reaching out to customers about their invoices. Invoice factoring immediately puts funds in your pocket, and you can get capital from this strategy even if you have a bad credit score. Companies look at the creditworthiness of your clients. They don’t need you to have a good credit score to receive invoice payments. You can then use the capital without worrying about monthly loan payments.
Merchant Cash Advance
A merchant cash advance can help small business owners who do not have the best credit. Business owners can obtain the cash advance right away and repay it over time with a percentage of each debit and credit card transaction. While this strategy can provide quick cash and help companies who can’t qualify for small business loans, the interest rates on these cash advances can get excessive. While each lender is different, you could be looking at an APR above 100% from one of these cash advances. It’s important to review other options and see if you can find a lender with a more generous credit score and revenue requirements. A merchant cash advance should be one of the last choices you consider.
Where Can You Get a Business Loan?
Several lenders offer business loans. We’ve compiled a list of choices to consider.
SBA Lenders
The Small Business Administration backs business loans with competitive terms. SBA loans come with lower down payments and don’t always require collateral. Borrowers receive continued support and business education from the SBA. Borrowers can receive a business loan between $500 and $5.5 million from the SBA. While these loans have competitive rates and terms, they have higher credit scores and revenue requirements. These loans also take a while to receive. It can take 30-45 days for you to receive capital from an SBA loan.
Banks and Credit Unions
Banks and credit unions offer several types of loans, including business loans. These bank loans are more challenging to obtain but often come with better terms and rates than the competition. Banks are more stringent about their requirements, while credit unions have less advanced technology and fewer branches.
Online Lenders
Online lenders are alternatives to traditional banking. Some private lenders emerged in response to flaws in the traditional banking industry. They provide borrowers with the greatest amount of flexibility and choices. You can qualify for a loan and complete the application from anywhere. Some online lenders provide superior flexibility and lower rates and can approve your application within 24 hours.
