How Do Business Loans Work?

With rates, terms and repayment schedules varying significantly between business loan types, it’s crucial to understand exactly how your financing works before signing any paperwork. In this article, we’ll go over how business loans work, where to find them and how to qualify.

How do business loans work?

A business loan is a type of financing that gives entrepreneurs the capital they need to launch, grow and run their businesses. To get a business loan, borrowers will need to begin by finding a lender. We’ll talk more about where you can find business loan options a little later.

The next step is to submit a loan application. Most lenders accept applications online, though traditional banks may require you to visit a physical branch. You’ll need to give the lender information like financial statements, a copy of your business plan and details on any assets you plan to use as collateral.

The lender will use that information to determine the terms of your loan, including your rate and how much money they can offer. Once approved, you can expect to receive your funds in as little as 24 hours or up to 90 days, depending on the lender. Based on the type of loan, borrowers may receive their financing as a lump sum or in the form of a credit line.

In exchange for this financing, borrowers agree to repay their loan by making payments on a daily, weekly or monthly basis. These payments include fees and interest — the cost of borrowing money. If the loan is not repaid on time, the lender could consider the loan in default and seize the borrower’s collateral. For this reason, it’s important to only borrow what you can realistically repay.

How different types of business loans work

Business financing is available in many shapes and sizes. Let’s explore some of the most common types of business loans and how they work:

Term loans

With a term loan, you can expect to receive your funds up front as a lump sum payment.

Long-term business loans can have repayment periods of 5 years or more and are commonly used for big purchases or investments, such as real estate or machinery. Short-term business loans are catered toward meeting more immediate needs like payroll and need to be paid back more quickly.

Term loans are typically repaid on a weekly or monthly basis. Your payments will include a portion of the loan amount plus interest. Some lenders will require collateral, like real estate or equipment, to secure the term loan.

If the loan is unsecured, meaning it doesn’t require collateral, you may have higher interest rates, but you generally won’t risk losing your business assets. However, some loans that are advertised as unsecured require a blanket lien or a personal guarantee, so there are still risks involved.

SBA loans

The U.S. Small Business Administration (SBA) has several loan programs designed to help small business owners get funding. Though the agency doesn’t lend directly, it works with lenders and other organizations to provide loans to businesses that may not otherwise qualify for financing.

By backing these loans, the SBA reduces lender risk and increases lender capital. In turn, this makes it easier for small businesses to get the funding they need.

SBA loans come in a wide range of loan amounts and can be used for a variety of business purposes. To take advantage of these loan programs, you’ll need to be considered a small business.

Although the application and approval process for small business loans through the SBA can take longer, rates and terms may be more favorable compared to other financing options.

Business lines of credit

Unlike a term loan, which provides a lump sum of money, a business line of credit functions similar to a credit card, allowing you to borrow money as needed up to a predetermined limit for a set period of time. You can pay down the debt and then borrow against your line of credit again.

This makes business lines of credit a good option for borrowers who are unsure of the exact amount they need, especially since you’ll only be charged interest for the funds you actually use.

You generally won’t need a down payment to get a line of credit, and there are short-, medium- and long-term options. Lines of credit can be secured or unsecured, but unsecured lines of credit may have higher interest rates and smaller amounts of credit.

Equipment financing

If you’re in need of expensive equipment to run your business, equipment financing might be the best solution. Equipment financing is a type of term loan specifically designed to help business owners purchase the equipment they need.

This type of financing is typically used to purchase assets like work vehicles, manufacturing equipment or commercial ovens. With an equipment loan, the equipment acts as collateral to secure the necessary funding.

The business owner then pays back the loan (plus interest) according to a preset payment plan. Once the loan is paid off in full, the business owner becomes the full owner of the asset. However, if they default on the loan, the lender can take possession of the equipment.

Invoice financing and factoring

Unpaid invoices can create serious cash flow issues for business owners. Invoice financing is the process of using unpaid invoices as collateral to obtain a loan or line of credit. Essentially, you’re borrowing money that you’ve already made. Lender fees are deducted from the payment when the customer pays their invoice in full.

Invoice factoring is a similar arrangement. However, with this type of financing, unpaid invoices are typically sold to a lender for a cash advance. That lender is then in charge of collecting the payment from the customer. Once the customer pays the invoice, the lender deducts a fee before sending you the remaining amount due.

Merchant cash advances

A merchant cash advance is an alternative type of small business financing that allows business owners to sell a portion of their future income in exchange for a lump sum of cash. The business owner then repays the funds through a percentage of the business’s earnings — usually debit and credit card sales — until the advance is repaid, plus fees.

This can be beneficial for seasonal businesses, allowing you to pay back the borrowed funds in proportion with your sales. As such, when business is slow, your payments will be lower.

Compared to other forms of financing, merchant cash advances can be fairly quick to obtain and relatively easy to qualify for. However, it’s important to understand that these advances can come with high rates and confusing terms, making this one of the most expensive types of business financing available.

Business loan agreements: Key terms to know

First-time borrowers may be mystified by the jargon used throughout the loan process. To minimize uncertainty, familiarize yourself with the following terms:

• Loan agreement: A legal contract between a lender and a borrower that outlines the key terms of the loan, including when and how you are expected to make payments on your debt and what will happen if you fail to do so.
• Origination fee: A one-time, upfront charge that is deducted from the total loan amount to cover the administrative costs of processing and underwriting a business loan application.
• Interest rate: A percentage of the loan amount the borrower agrees to pay in exchange for their financing. Interest rates vary based on the lender and the type of business loan. Credit scores, down payments and other factors will also impact your interest rates.
• Annual percentage rate (APR): A percentage representing the total annual cost of borrowing money, including the interest rate and any additional fees.
• Collateral: An asset used to secure a business loan, minimizing the risk for the lender and allowing borrowers to receive more favorable rates and terms. In the event of a default, the lender can seize the collateral.
• Blanket lien: An “all-asset lien” that covers most, if not all, business assets, including present and future inventory. If a blanket lien is established through a UCC filing, the lender has the legal right to seize all assets if the borrower defaults.
• Personal guarantee: Lenders may require you to sign a personal guarantee, which puts your personal assets on the line if you default on your loan.

Where to find a business loan

Rates and other loan terms differ greatly between lenders. To find the right loan for your business, you’ll need to consider several factors, including how much you can afford to repay, how quickly you need your funds and what you plan to use them for.

With these factors in mind, it’s time to explore your loan options. Both traditional banks and alternative lenders offer financing for small business owners, but each option comes with its own pros and cons. Here’s what you need to know:

• Banks: Loans from traditional banks typically require good credit and a decent stream of revenue. Because of this, new business owners may struggle to qualify. But for those who do, business loans from traditional banks usually offer the most affordable rates.
• Online lenders: Online lenders may be less strict when it comes to credit, time in business and annual revenue requirements, making it easier for new businesses and start-ups to find financing. However, these loans typically come with higher interest rates and smaller loan amounts.
• SBA lending partners: While the SBA doesn’t lend money to small businesses directly, it does partner with traditional and online lenders to help small business owners obtain financing. This can allow new business owners to lock in more competitive rates and terms.
• Loan marketplaces: Marketplaces like LendingTree make it easy to compare several business loan offers at the same time. This can help you find the right loan and lender for your unique needs.

How to qualify for a business loan

When applying for a business loan, lenders will generally consider your:

• Credit score: In general, lenders look for a personal credit score in the mid-600s and a business credit score of at least 80, though some lenders may offer loan options for borrowers with bad credit.
• Time in business: While some lenders may be willing to lend to start-ups, others look for at least two years in business to minimize their risk.
• Annual revenue: Lenders want to know that you have enough cash flow to repay your loan without any issues. Though these requirements can vary, many lenders require a minimum of $100,000 in annual revenue.
• Debt ratio: Lenders will also consider your debt-to-income ratio, which measures the amount of your monthly income going toward debt payments.
• Collateral: Some lenders may require collateral to secure your loan. Common forms of collateral include real estate and equipment. If you fail to make payments on your loan, the lender can legally seize your collateral to recoup some of the cash you borrowed.