Every business owner wants to stay in business and gain market share. Cash flow is a vital component of any successful business, but some companies need business loans to cover short-term gaps or make investments. Some business owners need cash to get the ball rolling, while others need funds to fuel established businesses. A small business loan could help you gain momentum and move your plans forward. But before you start applying, it’s vital to discover how they work so you’ll know the right type of loan for your needs.
What Is a Small Business Loan?
As the name implies, a small business loan is a funding source that caters to business owners. These loans improve cash flow and allow you to pursue more opportunities. You don’t have to wait several years to save enough money for a piece of equipment or another valuable asset. Instead, you can receive a lump sum and use it to cover the purchase. Small business loans come in many forms and are available through many banks, credit unions, and online lenders.
How Do Small Business Loans Work?
Every small business loan has the same premise: you borrow money today that you will have to repay over time. Lenders make money from administration fees and interest, while you can get a return on your investment by smartly allocating your capital. Loans have different terms, interest rates, qualifications, and other details, but they all follow the same model. Of course, this common model has variations, and we have compiled a comprehensive list of small business loan options and a breakdown of how they work:
Types Of Small Business Loans
Term Loans
A term loan is an installment loan that generally offers an affordable fixed interest rate, assuming you have good or excellent credit. Borrowers with bad credit scores may qualify, but the interest rate will be higher, and lenders may not offer as much capital.
Small business loans provide you with a lump sum of cash, payable in equal monthly installments over a set period. Some lenders let you extend the loan term to make monthly payments more affordable. With this strategy, you’ll pay more interest, but you will also have more cash flow each month.
Short Term Loans
Short-term loans have a similar structure as term loans but have briefer repayment periods. However, these loans usually have smaller principals and come with slightly higher interest rates. Still, you can save on interest, considering you’ll pay off the loan faster than you would if you had a traditional term loan product.
Business Line of Credit
A business line of credit operates like a credit card. You’ll get access to a pool of cash that you can pull from on an as-needed basis during what’s referred to as the draw period. You can make interest-only payments during the draw period. When it ends, the remaining amount that’s owed is converted to a loan that’s payable in monthly installments that could fluctuate over time since business credit lines usually have variable interest rates. You can continuously draw from your credit limit as long as you repay it, making it a more consistent funding source than business loans. You don’t have to reapply each time you fully pay off the credit balance, but you will have to reapply each time you repay a loan.
SBA Loans
SBA Loans are government-backed loan products that have steeper requirements but lower interest rates. SBA-backed loans often require loads of paperwork, and the application process for some SBA loan products can be lengthy. It can take over a month to receive funding through an SBA loan, even though you could get financing from other options within days. Contrary to popular belief, these loans are not available directly through the U.S. Small Business Administration. Instead, you’ll work directly with an SBA-approved lender to secure funding for your business.
Equipment Loans
Equipment loans are secured, which means the equipment you purchase with the loan becomes collateral. If you default on the loan, the lender has a right to take the property and sell it to recoup what they’re owed. While collateral increases your risk, it has a notable perk. Lenders offer lower interest rates when you use equipment as collateral. Some businesses use equipment financing to get out of the cycle of leasing equipment. Equipment leasing is like paying rent. The costs never go away until you purchase your own equipment. Equipment loans can decrease your cash flow in the short term relative to equipment leasing, but this financing provides long-term cash flow growth instead of leasing equipment.
Business Credit Cards
Business credit cards work like personal credit cards but with increased functionality. Most allow you to categorize transactions, and you could also earn rewards and cashback. You could earn those perks with a personal credit card, but business cards tend to provide superior rewards. However, you can only use business credit cards for business-related purchases. You could get in trouble if you use a business credit card for personal expenses.
Depending on the card you apply for, you may also get an interest-free promotional period. Some business owners transfer the balance from one credit card to another and capitalize on the introductory 0% APR timeframe. Avoiding interest accumulation for 6-18 months will make the credit card easier to pay off and provide some breathing room. It’s easy to find a business card that has a higher credit limit than your personal card. More money gives you more choices and a business credit card delivers.
While this financing option is more convenient than small business loans, these cards have much higher interest rates than loans. Business credit card APRs aren’t a problem if you can pay down the balance each month; that activity will improve your score. In addition, a higher business credit score will help you qualify for better financing in the future. However, a business credit card can put you deeper into debt if you can’t get rid of the balance soon enough.
Merchant Cash Advance
While a merchant cash advance technically isn’t a loan, it is a form of financing based on your projected sales volume. If you’re eligible, the lender will give you a lump sum of cash and collect what they’re owed by taking a set percentage of your credit or debit card sales each day.
It’s relatively easy to qualify for a merchant cash advance, but the fees could make the cost of borrowing outweigh the benefit of getting the cash you need. To illustrate, if you’re approved for a merchant cash advance of $25,000 with a factor rate of 1.5, you’ll pay $12,500 in fees. Costs can add up even more if sales slow down and force you to repay the cash advance behind schedule. So, while a merchant cash advance is one option for getting a loan, it’s primarily used as a last resort.
Invoice Factoring
Invoice factoring entails selling your invoices to a lender in exchange for immediate payment. You’ll receive a percentage of your invoice’s value, and the lender will pursue payment for what’s owed. This strategy can work well for business owners who can’t wait for the invoice payment’s deadline or have several clients who have missed payments.
Unlike the other financing options, invoice factoring does not add debt to your balance sheet. This financing method can help you avoid high interest rates if you have bad credit or get rejected for a traditional business loan. You won’t have to worry about allocating some of your cash flow to making monthly payments for a business loan.
However, the invoice factoring company will communicate to your customers on your behalf and request money. This can be a good thing or a bad thing, depending on how you look at it. While you won’t have this responsibility anymore and can focus on other things, an invoice factoring company can hurt your relationship with a client by being too aggressive about receiving the payment. Invoice factoring is better than merchant cash advances, but you should carefully consider how giving invoices to a company could impact your relationship with customers.
Working Capital Loans
If you want a solution to cover operational costs, working capital loans are for you. However, these financial products generally have smaller amounts and shorter repayment periods than what you’ll get with a term loan. Therefore, you should use a different type of loan for a long-term investment.
How To Get a Small Business Loan
Now you know your options. The next step is to decide which loan is best for you and apply for it. You should compare lenders and discover which loan best fits your needs. For example, equipment financing is optimal for equipment purchases, but if you have numerous unpaid invoices and don’t want to incur more debt, invoice factoring can be for you. We’ve made it easy to know what you need to prepare your application and qualify for a loan. Most lenders require the following when you apply for a small business loan:
Business Plan
Not all lenders require a business plan, but it doesn’t hurt to have one on hand, just in case. It should include an overview of your business, a description of the products and services you offer, a list of key officers and managers, a market analysis, a sales and marketing plan, and financial projections. Even if the lender does not require a business plan, it’s helpful to create one that you and your team can review. Updating an old business plan to reflect new objectives and opportunities can provide more clarity as you strive to grow your company.
Business Financials
Business lenders will request several documents during the application process. Here are some of the documents a lender may request:
- Bank statements for the last three to six months
- A profit and loss statement
- A balance sheet
- Your two most recent business and personal tax returns
- A schedule of business debts
This list of documents can expand depending on where you get your loan. Consult with your lender to learn more about the documents you need to apply for a loan so you don’t hit any speed bumps during the application process.
Credit Scores
Most lenders will check your personal and business credit scores to determine if you’re a good fit for funding. They set minimum requirements and offer the best interest rates to people with good credit scores. If you have bad credit, you can still get a loan, but you will have higher monthly payments. You can review your credit reports to find any errors leading up to an application to get some quick momentum. Making on-time payments and reducing your balances on other debt will have a more potent impact on your score.
Some lenders will also require a business credit score. This score helps lenders understand your company’s financial health. A strong personal credit score alongside a weak business credit score can hurt your chances of getting favorable loan terms. However, a strong business credit score will help you get higher loan amounts and lower interest rates. If you haven’t yet established business credit, you can get started with Dun & Bradstreet. Registering with them will generate a D-U-N-S number, a free 9-digit number that identifies your company’s physical location(s). Lenders can use this number of your EIN to monitor financial activity and discover your business credit score.
Collateral
Not all small business loans require collateral to get approved. But if you’re seeking a loan for an acquisition related to equipment, inventory, or real estate, it could be a requirement. Lenders can take the collateral if you fall behind on loan payments. Most lenders will work with you to avoid this scenario, but the risk exists for any loan that requires collateral. The upside to these loans is that they usually come with lower interest rates. Lenders give borrowers more favorable terms if they can offload some of the risk involved.
