How Do Business Loans Work?
Entrepreneurs and business owners seeking funds to help maintain or grow their operations can often find assistance through business loans. There are various types of business loans available depending on your needs and circumstances. Business loans can differ greatly when it comes to details like the type of loan, the loan’s terms and rates and the method and length of payback.
We’ll discuss the basics of what you should know about getting a small business loan, and how to decide which loan is right for you.
What is a small business loan?
Business loans are a way that entrepreneurs can obtain the capital necessary to run their businesses. Business loans are often available from sources such as banks or online lenders — the U.S. Small Business Administration (SBA) also helps to facilitate the lending process.
Funding is available for a variety of different uses in amounts that typically go up to $5 million. Components including your business and personal financial history and industry, as well as your company’s financial statements and length of time in operation, are all typically taken into consideration by lenders. Business loan payments are sometimes structured in the form of consistent installments, but they can also be dependent on cash flow or set up as revolving credit payments. Interest rates and fees are dependent upon the type of loan, the lender and the agreed-upon terms.
Types of business loans
Business financing is available in a wide range of forms to suit specific needs for different business owners. Below we’ll discuss how small business loans work, and several common types of business loans:
Term loans are a lump sum of funds that are typically paid back at regular intervals. They can be obtained as short-term or long-term loans, and the conditions of the loan often depend on the loan amount and what it’s used for. Long-term loans are commonly used for big purchases or investments like real estate or machinery, while short-term loans are catered towards meeting more immediate needs like payroll.
The periodic repayments of term loans usually include both interest and a portion of the original borrowed amount. Some lenders will require collateral, such as real estate or equipment, to secure the loan. If the loan is unsecured (meaning it doesn’t require collateral) you may have higher interest rates, but you wouldn’t risk losing business assets.
The SBA has several loan programs designed to help facilitate the lending process for small business owners. The agency doesn’t typically lend funds directly, but instead works with lenders and other organizations to help provide the loans, often for businesses that may not otherwise qualify. It sets guidelines for the loans, reduces lender risk and makes it easier for the lenders it works with to get capital; this in turn allows small businesses more access to that funding.
SBA-guaranteed loans are available for a wide range of amounts and can be used for a variety of business purposes. Businesses must typically meet the SBA’s size standards and other basic requirements in order to take advantage of its loan programs. The application and approval process for these loans can take a longer time, but rates and terms may be more favorable compared to other financing options.
Business lines of credit
Rather than one lump sum of money, a business line of credit gives ongoing access to funding up to the credit limit amount — plus, you’re only charged interest on the funds you use. On a revolving business line of credit, once the debt is paid off, the business owner receives access to the full amount of credit again.
Business lines of credit tend to offer flexible financing and quick access to capital. A down payment isn’t required, and there are short-, medium- and long-term options. Lines of credit can be both secured (collateral required) or unsecured (no collateral necessary), but unsecured lines of credit may have higher interest rates and smaller amounts of credit.
Equipment financing is typically used by business owners to purchase assets like manufacturing equipment or commercial ovens. With this type of financing , the equipment acts as collateral to secure the necessary funding. The business owner then pays back the loan (plus interest) according to a payment plan.
Once the loan is paid off in full, the business owner becomes the full owner of the asset. If they default on the loan, however, the lender then takes possession of the equipment.
Unpaid invoices can often create 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 specific type of financing, unpaid invoices are typically sold to a lender for a cash advance; that lender is then in charge of collecting payment from the customer. When a 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 example of financing in which a business owner sells a portion of their future income to merchant cash advance providers in exchange for a lump sum of money. The business owner then repays the funds through a percentage of the business’s earnings (typically credit card sales) until the advance is repaid, plus fees.
Typically, merchant cash advances are fairly quick to access and are available for businesses that may not qualify for other options. The format can be beneficial to seasonal businesses, as you pay back the funds in proportion with your sales; as such, when business is slow, your payments will be lower. However, merchant cash advances can come with high rates and confusing terms — it’s one of the most expensive types of business financing available.
Commercial real estate loans
Commercial real estate loans are designed for the purchase or development of commercial property. There are several different loans options available, though traditional commercial real estate loans are typically structured similarly to a residential mortgage. The property acts as collateral and repayments happen according to the loan terms.
Commercial real estate loans tend to have long repayment terms, and can be obtained for amounts up to $5 million or more. Most require that at least 51% of the property be occupied by the owner.
Where to get a business loan
Business owners can apply for loans from traditional financial institutions like banks, as well as through alternative sources, including online lenders. Resources like the SBA are also available to help facilitate the loan process for small business owners.
Business owners can turn to online lenders when seeking a loan. Online lenders typically require less documentation and may have more lenient requirements and faster time to funding than banks. At the same time, online lenders will often charge high interest rates and provide smaller funding amounts.
Many business owners will begin at the bank when seeking a loan — it’s likely they’re familiar with the financial institution, already have accounts there and perhaps even know some of the bankers at their local branch personally.
Traditional banking business loans often best fit the needs of established business owners with documentation of good credit and substantial revenue. Qualifying for a bank loan can be an extensive and time-consuming process; however, business owners may receive access to larger amounts of funding, with competitive rates and terms.
SBA lending partners
The SBA itself doesn’t usually directly lend money to small businesses — instead the agency partners with banks, online lenders and other financial institutions to help small business owners obtain loans. The federal government guarantees a percentage of the loan and repays the lender if the loan were to default. The SBA’s efforts reduce lender risk and makes capital easier for lenders to access, which enables small businesses to find funding at competitive rates and terms.
What you need to apply for a business loan
In addition to your loan application, lenders may require business owners to provide supporting documents or information. The necessary documentation varies by loan type and lender requirements.
When applying for a loan, business owners are commonly asked to provide the following information:
- Business bank account statements and tax returns
- Details on available collateral
- Business balance sheet
- History of cash flow and future projections
Personal financial information may be requested as well.
What to keep in mind before applying for a business loan
The process of applying for a business loan will move more quickly if your paperwork and record keeping is in order. Make sure to:
- Fix any accounting errors
- Check your personal and business credit and correct any mistakes in your credit reports
- Get advice
Ken Alozie, a mentor with small business assistance nonprofit SCORE, recommends reaching out to your local SCORE or Small Business Development Center (SBDC) offices to find advisers who can help to prepare you for the loan application process. SCORE provides free advice and mentorship to small business owners, while SBDC is supported by the SBA.
How do business loan payments work?
The repayment process for business loans varies depending on the type and conditions of the loan. Typically, the business is responsible for repaying debt — however, if a personal guarantee was signed, then the business owner would be held liable if the business loan were to default.
Here are a few of the most common payment options for business loans.
Terms loans are lump-sum amounts of funding that are usually repaid by a set schedule of installments. Short-term loans can have quick repayment schedules through daily or weekly payments, while long-term loans tend to have a monthly payment structure.
Revolving credit payments
Business lines of credit and business credit cards tend to be revolving, which means that the full credit limit becomes available again after the debt is repaid. Interest is only due on the funds that were used.
Cash flow payments
Sometimes payments can be deducted directly out of a business’s income. Examples of cash flow payments include merchant cash advances (in which payments are made from a percentage of daily sales) and invoice financing (where payment comes out of a business’s invoices).
Other FAQs about how business loans work
How do you qualify for a business loan?
Qualification requirements depend on the lender and type of loan you’re looking for — lenders often want to see business and personal financial documents and details about the business’s history, among other information. Some lenders will approve applicants with personal credit scores as low as 500, though a credit score of 680 or higher will most likely result in more favorable rates and terms.
How do you pay back a business loan?
Repayment for business loans will depend on the lender’s requirements and the type of loan. Loan repayments are commonly structured as installation payments, revolving credit payments or cash flow payments. Frequency may be daily, weekly or monthly.
How much money do I need to get a business loan?
There are business loans available that don’t require a down payment, although you may need to provide collateral to secure the loan. Many financing options for small businesses offer various levels of flexibility and financial requirements. Most business loans will require proof of business income or sales — a minimum requirement of about $10,000 in gross monthly revenue is typical.