Every business needs cash flow to stay in business and gain market share. Some of these businesses can sufficiently tap into their revenue, but others need to borrow money in the beginning. Some startups use a small business loan to generate momentum, and there are many seasonal businesses that take out loans during the slower months. Business owners can choose from several small business loans. This guide will explore the key options and how to choose the best loan for your needs.
What Are Small Business Loans?
Small business loans are financial products that give business owners extra capital for their companies. These loans have payment structures and interest rates that dictate how much you owe and how frequently you pay back the loan. When determining what to offer, lenders look at your business experience, revenue, credit score, and other details. Some businesses use small business loans when their seasonal businesses are in their slower months or if they want to make ambitious investments to gain more market share.
What Can You Use a Small Business Loan For?
Business owners can use a small business loan for any expense. While you can technically use a small business loan for some personal expenses, most business owners use this financing for business investments. Some business owners use these loans to buy commercial properties or invest in advertising. Other business owners use these proceeds to pay salaries during slower months or purchase new equipment. You’re free to use these funds in any way that you choose.
Understanding Small Business Loan Terms
There are a few key terms to understand before taking out a small business loan. These are some of the basic details.
APRs and Interest Rates: How They Work
APR and interest rates dictate the cost of borrowing money. The interest rate reflects the percentage of the loan amount that you must pay back. Lenders set an interest rate to reflect the amount of risk they take for giving out loans. APR is a more accurate reflection of how much you owe since it entails interest, fees, and other expenses involved with getting a loan.
Secured vs. Unsecured Loans: The Role of Collateral
Some lenders require collateral before giving you money. This is a common practice for any mortgage lender who is helping you buy a house. In this case, you are receiving a secured loan. If a borrower defaults on a secured loan, the lender can take the collateral to compensate for the default.
Unsecured loans do not have any collateral. If the borrower defaults on the loan, the lender cannot obtain an asset in return. While secured loans have more risk due to collateral, these loans also have lower interest rates. Unsecured loans are more expensive than secured loans in the long run.
Common Types of Small Business Loans
Small business owners can choose from many types of loans. While alternative financing offers even more choices, these are some of the common picks among business owners.
Business Term Loans
Business term loans offer a lump sum capital payment and then allow you to make daily, weekly, or monthly payments back toward the loan. Most lenders let you make monthly payments, so you have access to the capital for a little longer.
Term lengths and credit score requirements vary for each lender. Most business term loans are 3-10 years and require a 600 FICO score or higher. Having a higher credit score will help you secure better terms. You may need at least 1-2 years of business experience to qualify for a loan. Many small business lenders also set revenue minimums that often range from $100,000 – $250,000 per year to get financing.
Some lenders start as low as $5,000 and let business owners borrow as much as $5 million.
SBA Loans
SBA loans are the most challenging business loans to obtain. You will need a 640 credit score or higher to obtain the popular SBA 7(a) loan, but a 680 makes it easier to get approved. You can borrow up to $5 million and receive some of the lowest interest rates in the market.
These loans help business owners fund long-term projects. SBA loans aren’t the best financial products for covering short-term expenses due to how long it takes to get financing. It can take 60-90 days after submitting your application to finally get approved. Working with an SBA-preferred lender can speed up the process, but business owners are still looking at lengthy timelines.
Business Lines of Credit
Business lines of credit allow you to receive a credit limit, which is just like a credit card. Some business owners opt to get a business credit card instead of a business line of credit, but both financial products can help you access more capital. Business lines of credit have variable interest rates instead of the fixed interest rates that are more common for business term loans.
You only pay interest on a business line of credit when you borrow money against the credit limit. In theory, you can have a business line of credit as extra reserves and avoid interest by never borrowing against it.
You initially only have to make interest payments during the draw period, but repaying the balance in full will help you save the most money. Once the draw period concludes, the remaining balance gets converted into a traditional loan with daily, weekly, or monthly payments. Business lines of credit usually have easier requirements than small business term loans.
Equipment Financing
Equipment financing allows business owners to finance equipment purchases. Most of these loans have 3-5-year terms and allow you to put as little as zero money down. Putting down less money will result in a higher interest rate and higher monthly payments. You usually need a 600 credit score or higher to get a loan.
Many lenders let you finance purchases for new and used equipment. Since used equipment comes with more risks due to wear and tear, equipment loans for used equipment usually have higher interest rates.
Merchant Cash Advances
Merchant cash advances are easier for business owners to obtain since the credit score requirements are either very low or nonexistent. However, these cash advances get expensive in a hurry and are practically payday loans for business owners.
Business owners can receive funds within a day, and the application process is quick. You only have to provide your personal details, business information, bank or credit-processing statements, and tax returns. Merchant loans have factor rates that are similar to an interest rate.
If your merchant cash advance has a 1.30-factor rate and you borrow $5,000, you will have to pay a total of $6,500 throughout the merchant cash advance’s duration. That’s an extra $1,500 on top of the principal. However, these loans use a percentage of credit and debit card sales for repayment. If your business does not generate enough activity in a short amount of time, the debt will grow over time. An MCA lender can access your bank account and use those funds to pay off the debt if you default on a merchant cash advance.
Working Capital Loans
Working capital loans are best for short-term expenses, such as payroll and inventory. Most small business lenders use the same requirements for working capital loans as they use for their small business term loans. The products are very similar, but small business term loans are more suited for long-term investments.
How to Choose The Best Type of Business Loan
Are you wondering which loan is right for you or how to spot a great offer? These are two key factors to consider.
Loan Terms
Some business owners can afford to make monthly payments for a business term loan, while others want to get started with interest-only payments through a business line of credit. The length of the term also matters since a 5-year loan has higher monthly payments than a 10-year loan. However, the borrower with a 10-year loan stays in debt longer and ends up paying more in interest.
Loan Amounts
Small business owners have to make sure the loans they receive meet the necessary requirements. If you need a $100,000 loan right now, don’t settle for a loan that only gives you $50,000. Consider how much you need before applying. You may have to extend your loan’s duration for the lender to feel more confident about lending a significant amount of capital.
Typical Eligibility Requirements to Qualify for a Small Business Loan
These are some of the requirements you may come across as you apply for small business loans.
Time in Business
You may need 1-2 years of business experience to qualify for a small business loan. Having more years of experience will open up more opportunities and can possibly help you secure a lower interest rate. However, lenders will more heavily consider annual revenue and credit scores when determining your rate.
Annual Revenue
Your business may have to generate $100,000 to $250,000 in annual revenue to qualify for a business loan. Each lender has different rules, and you can find lenders that offer financing even if your company is pre-revenue. Unfortunately, these loans tend to have lower amounts and higher interest rates since the lender incurs a greater risk.
Business Industry and Size
Some lenders have a blacklist of industries they will not work with. You should make sure the lender works with companies in your industry before you submit an application. The size of your business also plays a role in the type of financing you can receive. Larger businesses can usually access higher loan amounts.
Business Plan, Financial Statements
Some lenders will request a company of your business plan along with your financial statements. These documents help lenders assess your financial health and how you plan to use the capital. You don’t have to follow the business plan to a tee, but lenders may want reassurance that you know how you intend to use the funds.
Credit Scores: Personal and Business
Any lender with competitive rates and terms will request your credit score. Most business lenders let you get financing if you only have a personal credit score. However, some lenders may also require a business credit score.
Higher scores entitle you to lower interest rates and higher loan amounts. You can increase your credit score by paying everything on time. Payment history makes up 35% of your personal credit score. Credit utilization ratio, a stat that measures the percentage of your credit limit you have borrowed against, makes up 30% of your personal credit score. If you pay your credit card in full each month, you are strengthening core components that makeup 65% of your credit score.
Collateral
You may have to provide collateral for a small business loan. Collateral is an asset a lender can claim if the borrower defaults on the loan. Some loans require collateral, such as equipment loans. Small business term loans and business lines of credit are often unsecured loans. While loans with collateral carry more risk for the borrower, these loans tend to have lower interest rates than unsecured loans.
Types of Business Lenders
You can choose from many business lenders, but they each belong to one of these categories. Understanding how these types of lenders work can help you filter the options and find the right lender for your needs.
Online Lenders
Online lenders have the fewest barriers to entry for business owners. Some of these lenders are direct lenders, and others are business loan marketplaces that connect business owners with dozens of lending partners. These loans have relatively low credit scores and revenue requirements, and you can receive funding in as little as 24 hours.
Direct Lenders
Direct lenders originate their own loans and give business owners the capital for their loans. Some direct lenders operate entirely online, while others operate at financial institutions. Direct lenders do not rely on partners to distribute loans.
Traditional Lenders
Traditional lenders have some of the best rates and terms, but they also have the most challenging requirements. You will need a high credit score, multiple years of business experience, and solid revenue numbers to receive a loan from a traditional lender. It also takes longer to get approved from a traditional lender compared to an online lender.
Tips to Secure a Small Business Loan
Securing a small business loan can give your company the financing it needs to increase revenue or maintain operations. Following these tips can increase the likelihood of securing a small business loan and getting the financing you need.
Evaluating Your Business Needs
You don’t want to ask for too much or too little capital. Asking for too much money will result in higher interest payments, and you will need a second loan if you don’t get enough funds the first time. Evaluating your company’s finances and objectives can help you decide how much money your business needs.
Enhancing Your Business Credit Score
A higher business credit score will give you more financing options. Some business lenders will only consider your business credit score instead of looking at your personal credit score. A higher business credit score also allows you to secure lower interest rates and higher loan amounts.
Business owners have many ways to improve their credit scores. They can keep old lines of credit open, but most of your success will depend on your ability to pay bills on time. If you cover your business credit card balance every month in full, your business credit score will go up. The more financially responsible you are with your personal and business obligations, the more your score will rise.
Strengthening Your Business Plan
Many small business lenders will request a copy of your business plan during the loan application process. Lenders want to make sure the money will get well spent since they need that outcome to increase the likelihood of receiving their principal back with interest. A better business plan will make lenders feel more confident about giving you money. Even if a lender does not request your business plan, improving this document can help you achieve key milestones for your company.
Every business owner should have a detailed plan. This plan should list your company’s strengths, weaknesses, opportunities, and threats. It should also outline how you intend to use capital and offer revenue and earnings projections over the next few years. Business plans also contain action items that the company must perform within the next few days, weeks, and months to achieve long-term goals.
Deciding on the Type of Business Loan and Lender
Business owners can choose from several types of loans. Business term loans, lines of credit, equipment loans, and merchant cash advances are some of the traditional financing options. Business owners can further expand their horizons with alternative business financing methods.
Once you decide on the optimal type of business loan, you can filter your search to the right lender. Knowing what you want before applying for loans can save you time and help you find a loan that suits your financial needs.
Is a Business Loan Right for You?
A business loan can give your company financing to cover important expenses. However, these loans result in extra monthly expenses, and interest can accumulate if you only make the minimum payment.
Every business owner can use extra money, but it is important to consider the strings attached to loans. You will get extra capital now but face extra cash flow challenges in the future until you pay off the loan. Getting into a cycle of borrowing money to address short-term expenses can also lead to financial ruin. There are some exceptions to this rule, such as seasonal companies that generate the majority of their revenue within a few months.
Business loans let you make investments sooner and are the most plausible solution for some expenses. It’s more practical for most business owners to take out a commercial mortgage than it is to save up enough money to buy a commercial property. Business owners should consider how they will allocate the capital and how these investments measure up with the long-term business plan.
How to Apply for a Business Loan: The Typical Process
Ready to get started with a small business loan? You can complete the following steps to get the capital you need.
1. Find A Lender
Compare lenders to determine which one suits your needs. This process can take 1-3 days, depending on how many lenders you review and how deep you go into each analysis. It is a good idea to check online reviews on sites like Trustpilot so you can see what past customers thought about their experiences.
2. Submit Your Application
It only takes a few minutes to submit your application for most small business loans. These forms request some basic details and documents and make the entire process relatively seamless. After submitting your application, you will receive offers soon after. This process can happen very quickly with an online lender.
3. Review Your Offers
Once you have several loan offers, it’s time to decide which one is right for you. Small business owners should consider each loan’s fees, interest rates, terms, and other details. Once you decide on an offer, you can move on to the final step and get your capital.
4. Get Your Funds
Accepting an offer does not guarantee approval, but it’s very likely that you get the loan. Some lenders wait until you accept an offer to run a hard credit check. Many lenders let you input your own information when you receive offers and only run a soft credit check if that. Now, you will have a hard credit check, but if you get approved, you will receive funds.
The capital will go into your designated bank account. Then, you can use these funds to grow your business, maintain operations, and accomplish other key objectives.
