Business Loans

How Do Business Loans Work? Understanding the Business Loans Process

how do business loans work

When most of us think about applying for a loan, we envision sitting at a table across from a loan officer at a bank, and signing a stack of paperwork to finance something like a house, car, or business. But banks aren’t the only lenders in town–there are credit unions, online lenders and insurance companies. No matter which financial institution you chose to go with, there are dozens of loans types available to meet any funding needs a business might have.

In general, a business loan is a form of debt financing and a way to get money to grow your business. The important question is asking yourself whether you need, or can afford, a loan to begin with. If the answer is yes, then you’ll need to decide how much to ask for, what kind of loan you should get and where to get it from.

“Chances are, you’ll probably end up borrowing from other sources than a bank or multiple sources to achieve what you want to achieve,” said credit expert Gerri Detweiler, education director at Nav, a company that helps business owners access funding and make informed financial decisions.

Small businesses are certainly no stranger to loans. Loans through just the Small Business Administration (SBA) rose from 7.4 billion in 2013 to 11.5 billion in 2018 for their SBA 7(a) loan.

Before you fill out your first application, here are a few things to do first to make sure your business is in good shape:

  • If you haven’t already, write a business plan. Some loans request this for their required documents.
  • Get your personal credit score as high as possible and have a written explanation for any derogatory information on your credit report.
  • Make sure you can afford the loan payment. For loans that amortize, you can look at an amortization table online to estimate your monthly loan payments. Compare that to your current expenses and revenues.

Knowing how much money you need for a loan is something many business owners don’t actually know, Detweiler said.

“When they’re asked, ‘How much money do you want?’, they’ll say, ‘As much as I can get,’” she said.

That doesn’t always make for good business sense. Unless the loan is a line of credit, where you don’t pay interest until you borrow from the line, borrowing too much money can mean costly monthly payments and borrowing too little can mean missing out on the ability to grow your business.

When should you take out a business loan?

According to officials at the Women’s Business Development Center in Chicago, ideally a business owner would only take out a loan to buy or pay for something that would increase sales or create higher profit margins. That can include buying inventory or equipment and renovating or expanding the business.

The stage of your business will also affect your loan terms. Younger businesses will most likely pay higher interest rates on a loan and also find it harder to get a loan from traditional lenders. More established businesses will likely get more favorable rates and have an easier time getting a loan if the business has strong credit and revenue.

Banks are less likely to approve a loan for a business that is less than two years old, because they want to see at least two years of revenue statements. In that case, a newer business might want to consider looking at alternative lenders.

“Don’t be afraid to cast your net a little wide,” Detweiler said. “Especially if you don’t fall into that bank sweet spot of two years of operation, six figures or more revenue, and you’re not asking to borrow a substantial amount of money.”

Navigating the business loan process

You’ve decided a loan is a good idea for your business. So, what’s your next step? Start the process by doing some comparison shopping. That won’t be as easy as searching online because lenders aren’t required to disclose APR rates for small business loans, Detweiler said, but you can get a good feel of the requirements they have for giving out loans.

Detweiler said there are basically three main categories lenders look at to approve a business loan: credit, time in business and annual revenues.

“Depending on where you fall in those three categories…will tell you what type of loan might work for you,” she said.

For example, if you’ve been in business for more than two years, have good credit history and your business has at least $100,000 in annual revenue, a loan with a bank or credit union is probably your best bet in terms of getting a good interest rate. That’s assuming you can wait a couple of weeks or months to get approved for the loan. If you have poor credit or your business is a startup, you might want to look at an alternative lender.

Detweiler has a good rule of thumb for what to expect to pay in interest from different lenders.

“The more time and effort you put into getting a small business loan, the less you’re likely to pay,” she said. “The faster and easier it is to get a loan, the more you’re going to pay for that convenience.”

Types of lenders

Here’s a look at some of the most common types of small business lenders and what to expect from the loan process.

Traditional lenders: Most banks want to make money on your loan, or at the very least not lose money on the loan, so they tend to steer clear of “riskier” borrowers or make loans under $250,000 (unless they’re an SBA loan). Larger loans make the cost of underwriting the loan worth it, Detweiler said. In most cases, banks will want a longer time in business, better credit and more cash flow than an online lender will require. On the flip side, you’ll probably get the best interest rates with traditional lenders and they’ll have more options for you. Credit unions can potentially offer even better interest rates than banks because they’re a nonprofit. That means their profits go back to their members in the way of dividends, higher savings interest rates, lower loan rates or improved services. Getting a loan from a traditional lender will take longer, generally two weeks to a month, and you’ll need to fill out a lot of paperwork.

Minimum requirements:

  • Two years in business
  • A personal credit score of 680 or better
  • $100,000 in annual revenue
  • Collateral to secure the loan. Not every loan will require collateral, but having an asset to secure the loan can help you get the loan.
Traditional Lenders: Pros & Cons
Pros Cons
  Multiple types & terms of loans   A lot of paperwork & documentation required to apply
  Lower interest rates than alternative lenders   Solid credit history, time in business and revenue will be heavily considered.
  Depending on the size of the lender, they’ll offer many types of services & loans.   Loan approval can take 2 weeks & up to 2 months

 

Small Business Association (SBA): SBA loans are a very popular funding method for small businesses, and for good reason, Detweiler said. They have low interest rates, long terms, no balloon payments, no collateral requirement (on some loans) and they’re easier to get for younger businesses. The SBA loans the money directly to the borrower, but offers these loans through major lenders. The SBA then guarantees a portion of the loan, anywhere from 50% to 90%. The guaranty means that if the borrower defaults on the loan and the lender can’t recoup the lost money from the borrower, the SBA will pay back a portion of the loan. That makes it more likely for banks to give SBA loans to newer businesses or those who don’t meet some of their other requirements. That also doesn’t mean banks give out SBA loans to anyone. If too many borrowers default on an SBA loan, the lender can lose the right to offer those loans, Detweiler said.

Here are some requirements unique to SBA loans:

  • Must do business in the United States
  • Must be a for-profit business
  • Must have invested equity in the business
  • Must provide a business plan
  • Must meet the SBA’s small business size requirements, which can range from 100 employees to 1,500 employees, depending on the industry. Some industries, like crop production or forestry, are based on annual receipts rather than number of employees.

The additional factors that influence your loan decision will mostly be left up to the lender. Lenders might be more willing to give out SBA loans to borrowers with lower credit or time in business or annual revenue because the SBA provides a personal guaranty.

The SBA puts a lot of emphasis on a business plan, offering tips on how to write a plan here. They’ll want three years of financial projections, which is especially important for startup businesses who don’t have the financial history to show they can make money and pay off debt.

The SBA loan application is pretty detailed, and the loans can take a long time to approve, sometimes as long as two months. The SBA website offers tips and training to work with their loans, including how to prepare a loan package and the SBA loan application checklist.

SBA Loans: Pros & Cons
Pros Cons
  Long repayment terms   Rigorous paperwork & documentation
  Low interest rates   Hard to qualify
  Easier for startup businesses to get funding   Can take 1 – 2 months for approval

 

Alternative lenders: Alternative lenders are typically online lenders who will often loan money to borrowers with lower credit scores, less time in business and lower annual revenues. They almost always charge higher interest rates than traditional lenders because they are more likely to approve lower loan amounts. Approval for these loans is very quick, anywhere from two to 24 hours, and can be funded in just a day or two after approval.

Minimum requirements:

  • 6 or 12 months in business
  • $50,000 a year in revenue
  • 600 minimum credit score (some will go as low as 500)
Alternative Lenders: Pros & Cons
Pros Cons
  Easy application process   Higher interest rates
  Quick approval process   Shorter financing terms
  Easier to get approved with lower credit scores, less time in business and/or lower annual revenue.   Lower borrowing limits

 

How to qualify for a business loan: required documents

The process of applying for a business loan will depend on the type of lender. Most banks require you to apply in person at a bank branch. Some banks and credit unions have online applications for loans below a certain amount. Online lenders typically provide a short initial online form to get the process started, followed by a call from a funding specialist. Most online lenders only require three months of financial statements to apply. Here are some common documents you may need for traditional lenders:

  • Proof of business ownership
  • Personal and business tax returns
  • Business and personal financial statements
  • Profit and loss statements
  • A balance sheet
  • A business plan with financial projections
  • Copies of insurance policies
  • Articles of Incorporation or Articles of Organization
  • Proof of assets being used as collateral

What’s your industry?

It might seem like a strange thing to ask, but lenders will want you to identify the type of industry you’re in. That’s partly because lenders cannot grant loans to some industries, such as adult entertainment businesses, marijuana dispensaries, online gambling businesses and other lenders. Some reasons an industry is restricted from getting a business loan is due to state law restrictions or because the industry is considered risky.

You can look up which industry code to use for your business on the North American Classification System (NAICS) website. It’s important to get it right so your loan isn’t accidentally denied.

Knowing your industry well can also help you get a loan approved, especially with SBA loans, because it will signal to the lender that you understand your industry and have a good plan in mind to profit in the industry.

Types of business loans

The type of loan that will work best for you depends on multiple factors, such as how much money you need, how much you can afford in interest rates, how you’re spending money and how you will pay it back. Here is a look at some popular business loan options:

Business credit cards — These are revolving lines of credit that you can draw from up to an approved credit limit. If you don’t pay off the entire amount you’ve borrowed each month, then you’ll be charged interest on what you’ve borrowed. Business credit cards are good for smaller or short-term purchases like office supplies or travel expenses.

Business line of credit  — A business line of credit is similar to a credit card in that it’s a revolving credit line you can draw from at a capped amount, and you don’t pay interest until you borrow from the line. The difference is that a line of credit usually has lower interest rates and gives you access to cash, not just credit. These types of loans are good to cover unexpected expenses or opportunities or to cover cash flow gaps for seasonal businesses.

Term loan (short and long) — With a term loan, you get a lump sum of cash upfront and you agree to repay the loan in payments of principal and interest over a certain period of time. Term loans can be short (usually 3 months or less) or long (sometimes up to 25 years). They’re best used for a specific, large expense like a business expansion.

Equipment loans — These loans help you buy equipment for your business. The length of the loan is usually matched to the life expectancy of the equipment and the equipment serves as collateral for the loan.

Merchant cash advance (MCA)— With this funding type, it’s important not to think of it as a loan because you are borrowing against your future credit card revenues and will repay the advance with a percentage of those credit card receipts. A merchant cash advance may be good for businesses that have consistent and robust credit card sales and can’t easily or quickly get a loan elsewhere.

Invoice factoring and invoice financing — Invoice factoring is selling outstanding invoices to a factoring company in exchange for upfront cash. The factoring company will then collect on the invoices. Invoice financing is using your outstanding invoices as collateral to get a cash advance, but you’ll still be the one collecting the invoice payment. This is good for businesses who have regular paying customers, but are in need of fast cash.

Microloans — These are small loans ($50,000 and less) available through nonprofit lenders, including the SBA. They can be used for multiple business expenses, except to repay existing debt. Microloans are particularly aimed at startup companies, newer businesses and businesses in lower-income neighborhoods.

Business Funding Options: Pros & Cons
Loan/Funding Product Pros Cons
Business Credit Card No collateral

May come with rewards and special programs

High interest rate

Steep fee for cash advance

Lower credit lines

Business Line of Credit Pay interest only on what you borrow

Usually unsecured

Extra fees like maintenance and draw fees
Term Loan Higher loan amounts

Long and short-term repayment options

May require collateral or personal guarantee
Equipment Loan Favorable interest rates

Equipment serves as collateral

Loan term or lease may outlast the life of the equipment

May lose the equipment if defaulting on the loan

Merchant Cash Advance Quick and easy access to funding Costly option

Hidden fees

Invoice Factoring/Financing Access to cash is quicker than most loans Costly option
Microloan Low cost

Available for new businesses

Tough application process

Small loan amounts

 

Fees and other considerations

Along with interest rates, there are some other factors that determine how much a loan will cost. Pretty much every loan has a fee of some sort. According to the Women’s Business Development Center, lenders must disclose all their fees in your loan agreement. Here are some common fees to consider:

  • Maintenance fee: A yearly or monthly fee charged on certain loans.
  • Origination fee: A few charged to cover the cost of processing the loan.
  • Prepayment penalty: Rare on most small business loans, except those from the SBA. It’s a fee you’ll pay if you pay off your loan before a certain time.
  • Draw fee: Some lines of credit charge you a fee, usually a percentage of the line of credit amount, when you withdraw from the line of credit.

Business loans can also be secured or unsecured. A secured loan means you have collateral or a specific asset (your home, a car, equipment, certificates of deposit, etc) to secure the loan in the event of default. The lender would then have access to that asset to recoup their losses. Unsecured loans, which usually have higher interest rates, means you haven’t tied the loan to a specific asset. Most unsecured loans will come with a personal guarantee in case you default, giving the lender the right to sue you for the balance of the loan, plus interest.

Final tips

It’s important to do your homework before signing on the dotted line. Make sure you really need the loan, can afford the loan and weigh all lender and loan options to ensure you’re getting the best loan for your business. There’s no such thing as the perfect loan, but The Women’s Business Development Center offers these good borrowing guidelines:

  • Use short-term debt to pay for short-term debt and long-term debt to pay for long-term debt.
  • Make sure you have sufficient cash coming in to make the monthly payments.
  • Make sure you see a clear link between what you’re buying with the loan and an increase in profits.
  • Avoid paying higher interest rates to finance short-term assets like inventory or supplies.
  • Try not to carry too much business and personal debt.

At the end of the day, it really comes down to making sure you can afford to take on debt and that it will do something good for your business.

“If you know what you should use the money for, and what your return on your investment will be, it will make borrowing money a positive experience instead of a stressful one,” Detweiler said.

 

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