Types of Business Loans: The Ones to Know
Business owners often need extra funding. The hard part is figuring out the right source to get these funds. Financing options come in all shapes and sizes and from varying sources. Some are better for more established businesses, while others are more appropriate for startups. And all have particular considerations when it comes to interest rates, terms, qualifications and requirements. It’s important to do adequate research and know all your options before deciding what kind of loan or loans to pursue.
Steve Schillig, district director for the Ohio Small Business Development Center at Kent State University, has some suggestions for business owners trying to figure out their loan options. “I strongly encourage the client to prepare a monthly cash projection that reflects ‘true’ cash inflows and outflows and complete a project cost model that accounts for fixed assets and working capital,” he advised. “It is easy to account for the hard assets, but the working capital is often overlooked and creates the cash needs that materialize when actuality doesn’t match projections.”
General purpose loans
For established businesses
If you’ve been running your business for some time (especially five years or longer), you have a lot of advantages. You’ve learned the ropes, established your business model, and probably experienced both successes and failures. Depending on factors like your credit and revenue history, you may also be more attractive to more traditional lenders, like large brick-and-mortar banks (who, on average, approve only one-quarter of small business loan applications). Smaller or regional banks approve about half of all financing requests from small businesses and credit unions sign off on about 40%.
There are pros and cons to the conventional financing route and not all established business owners may select this option, but it’s generally more feasible for seasoned business owners compared to their up-and-coming counterparts.
Term loans (traditional banks)
Most traditional bank term loans are straightforward: Business owners borrow a set amount, which they repay at a predetermined interest rate over a number of years.
- Pros: Business owners who qualify can borrow a large sum at a competitive interest rate. These small business loans are typically among the most affordable in terms of interest rates on the market.
- Cons: Approval is hard to come by, especially for newer business owners. And even once you get approved, term loans—like other kinds of traditional loans (e.g., mortgages)—can take time to process and may require collateral.
- Consider if: You’re an established business owner with good credit, a solid revenue history, and time to wait for the paperwork to process. Term loans are typically used for significant growth initiatives, such as acquiring another company, purchasing real estate, remodeling, or dedicating money to expansion.
Lines of credit (traditional banks)
Lines of credit, which essentially offer access to an immediate source of cash, can give business owners peace of mind during unpredictable periods. With this product, the bank provides a specified amount of money to draw from, and the terms are either fixed or revolving (like a credit card).
- Pros: A line of credit is flexible—business owners only access it when needed. And typically, collateral is not required.
- Cons: These are also difficult to qualify for, may take some time to process, and may be subject to additional costs, such as maintenance fees.
- Consider if: Your business has a solid revenue history, your credit is good, and you want to pay for an emergency expense or need the flexibility of cash management during slower seasons.
Newer businesses or startups
Don’t lose hope if your business doesn’t have a proven track record. While you may need to wait patiently for the approval of larger banks, you still have some options beyond just relying on your personal savings or credit cards, both popular choices for new business owners. Nearly 60% of new business owners rely on their own cash to get started, while 23% turn to friends and/or family and 22% tap into their 401(k) funds.
Schillig has the following pointers for newer small businesses in search of financing:
- Start your new enterprise slowly and on a part-time basis, until you have a history of success that you can show a commercial lender.
- Use personal cash or savings. Consider turning personal assets (like equity in your home or vehicle or a collection) into cash.
- Consider leasing or renting equipment until cash flow can support the purchase.
- Don’t discount approaching family and friends. There are opportunities if you handle the approach professionally.
- Recruit investors, especially if you can provide a fair return.
- Explore crowdfunding, which is an online method of gathering upfront pledges or advance sales to fund a project.
Many traditional and online lenders will offer personal loans for borrowers with a credit score of at least 600 or better. The better your credit and financial history is, the better the terms you’re likely to get.
- Pros: Qualification is easier for personal loans than for traditional loans, and capital can be transferred relatively quickly.
- Cons: Interest rates can be high, and borrowing limits can be low (around $50,000). Late or missed payments can impact your personal credit history.
- Consider if: You’re a newer business owner with strong personal credit.
Rollovers for business startups
Also referred to as ROBS, rollovers allow aspiring business owners to access the assets in their 401(k) or another eligible retirement account to use for their business.
- Pros: If the transaction is earmarked as a rollover for business, there is not a penalty for early withdrawal. And because it’s not a traditional loan, there is no interest. Your credit score and other factors don’t come into play to get the money.
- Cons: ROBS can only be used to start a new business or purchase another company. As always, tapping into your retirement savings is always a risk, and ROBS can be expensive since companies usually charge a high fee to set them up and administer them.
- Consider if: You’re a new business owner with ample retirement savings and will be establishing your business as a C-corporation.
The Small Business Administration (SBA) supports American entrepreneurs by guaranteeing loans that banks and other lenders provide to small business owners. While rates on SBA loans are not usually quite as competitive as ones from a bank directly, approval may be easier for less-established businesses and the rates are far lower than online lenders.
There are several types of SBA loans for different purposes and scenarios, but the most common are SBA 7(a) loans, the funds from which can be used for nearly any business purpose. Specialized SBA loans include SBA 504 loans (for purchasing real estate), export loans (for financing export activity), microloans (for amounts less than $50,000) and disaster loans (to aid businesses affected by a natural disaster).
- Pros: There is no minimum requirement, and the maximum loan amount is roughly $5.5 million. Rates are relatively low, and the repayment terms are typically long.
- Cons: Depending on the type of loan, there may be restrictions on how the funds can be used. The application process is also lengthy and time consuming.
- Consider if: You’re a new or established business owner with good credit and a need for long-term general financing or short-term cash for a particular purpose.
Online or “alternative” lenders offer term loans that are logistically similar to traditional loans but come with a higher interest rate and usually a shorter repayment term.
- Pros: Online business loans may be a better option for newer business owners, especially those with lower credit scores.
- Cons: High interest rates.
- Consider if: You need cash quickly and have less-than-perfect credit.
Business loans for specific needs
Used to finance the purchase or lease of new or old equipment, equipment loans are typically repaid over the expected lifespan of the product financed, which acts as the loan’s collateral. Interest rates will depend on your credit score and business health, but also on the value of the equipment.
- Pros: Rates are relatively low, and terms are flexible: “equipment” can include vehicles, for example.
- Cons: The equipment can lose value and/or become obsolete before the loan is repaid.
- Consider if: You want to purchase equipment outright and can borrow at a competitive rate thanks to good credit or business strength.
Hard money loans
Hard money business loans are often backed by collateral (often real estate) and are easier to get for borrowers with lower credit scores or who need cash quickly.
- Pros: Financing is easier to secure for less-established business owners (or those with lower credit scores).
- Cons: Rates are generally high, and lenders will often not finance the entire loan, requiring supplemental financing for the purchase. Terms are short and many borrowers end up needing to refinance into another vehicle as the hard-money loan expires.
- Consider if: Your credit history is flawed and you have your eye on capital assets.
Invoice financing uses unpaid invoices as collateral to secure a cash advance, which is usually equal to a percentage of the invoice, but not the entire amount.
- Pros: Your customers won’t know you’ve borrowed against their invoices and funds can be acquired quickly.
- Cons: Rates are steep, and you are still ultimately reliant on your customers.
- Consider if: You are worried about unpaid invoices and need a ready source of cash.
SBA Disaster Loans
Sponsored by the SBA, disaster loans can benefit business owners who can prove their business has suffered due to a physical or economic disaster. Loan amounts can be up to $2 million for applicants with decent credit, and repayment terms are generous (up to 30 years).
- Pros: Interest rates are low, and requirements (such as credit score) are not as stringent as other options.
- Cons: Collateral is required, along with proof of business injury.
- Consider if: Your business is located in an area that the SBA has declared a disaster, and has suffered as a result.
There are several nonprofits that are in the business of providing loans to new businesses, particularly those owned by women and minorities. These organizations often focus on underserved communities that can benefit from businesses coming to the area.
- Pros: Interest rates are relatively competitive compared to other need-based loans.
- Cons: Terms are on the shorter side, and loan amounts are relatively small.
- Consider if: You have an equally strong character and business plan.
Other loans for fast cash
Despite careful budgeting and best-laid plans, emergencies will inevitably happen, some of which will require financial help. Among these short-term options are short-term loans and merchant cash advances. The former is just what it sounds like—a loan that must be repaid within a short time period, typically up to 18 months. A merchant cash advance, or MCA, is an agreement wherein the lender provides cash in exchange for a predetermined percentage of your daily (or sometimes weekly) credit card sales. While convenient, the repayment terms can be extremely steep—as much as 200%.
Business credit cards are another option and function like any other credit card, with a revolving credit limit which can be accessed as needed and repaid on a monthly schedule. You may pay an annual fee and a high interest rate; on the plus side, many business credit cards offer cash or other rewards.
- Pros: Can be an option for borrowers with less-than-perfect credit; access to cash is quick.
- Cons: Financing charges are higher than many other options, and these are not a good solution for long-term needs.
- Consider if: You may not qualify for other types of funding and you need access to cash immediately.
The bottom line
Many factors will go into the financing source or sources that work best for your personal and business goals. It’s also important to be realistic about what kinds of loans you have a good chance of qualifying for before applying, as each application will come with a credit inquiry that can result in a temporary lowering of your credit score. The best way to fund growth, Shillig said, is a combination of internal (your own money) and external sources (public or private lenders).