How Do Business Loans Work?
A Small Business Loans Guide
It’s common for business owners to wonder how business loans work. At some point, a company is bound to need a small business loan. Taking out a business loan offers many benefits. The primary benefit is leverage. A business's own financials take it so far, but with the right business loan, that business can expand, grow, and possibly dominate their market.
Companies take out small business loans to purchase real estate, increase cash flow, hire new staff, and even purchase equipment. The idea is to take out a business loan to help give a business a competitive advantage.
Small Business Loan Articles and Tools
How Do Business Loans Work?
Essentially, small business loans work in the following way: There are companies that specialize in lending money to businesses. They are called lenders. Lenders make money by charging interest and fees to businesses that borrow money from them.
Here are some things you need to know about lenders and business loans:
- Every vendor is different. It's important to know the loan requirements each lender has before they will approve a business loan. It's important to do your due diligence and carefully research each lender to ensure you comply with their requirements. You may not be able to comply with every lender's requirements; in which case, you should exclude these lenders from your list. There's no point applying for a loan you don’t qualify for.
- There are different types of business loans. It's important to consider your business's needs before deciding which type of loan to apply for. There's no point in applying for a real estate loan if you need money to hire new staff. It's important to research the different types of business loans to decide which business loan is right for your business needs.
- There are different loan repayment types. It may seem like getting a small business loan is the hard part. For most businesses, repaying the debt is the real challenge. Fortunately, businesses have loan repayment options. It's important to know what your options are before deciding which loan to select. If your business struggles with cash flow issues, a short term loan might be a better choice than a long term real estate loan.
- Watch out for predatory business lenders. Lenders prey on businesses that are cash strapped and need money now. They charge outrageous interest and fees. These types of lenders cloud the loan application process and often withhold important information or, at best, hide that information in the small print. These types of loans can bankrupt a company if the business owner isn't careful.
Business Loan Requirements
When applying for a business loan, there are some standard requirements most lenders expect. You should know what these requirements are before applying for a business loan.
Here are some standard business loan requirements:
Personal and Business Credit Scores
First, it’s important to know what your personal and business credit scores are.
Many lenders rely on this score as a risk assessment used to determine the likelihood of repayment. Creditors will also check your business credit scores. There are three main business credit bureaus: Dun & Bradstreet, Experian Business, and Equifax Small Business.
They record business information on nearly every business in existence and report payment history and debt in these reports. These credit bureaus generate a credit score based on the information in the credit report.
The higher the credit score, the more likely you are to be approved for small business loans. Make sure to pull both your personal and business credit reports to ensure you have a high enough favorable credit to qualify for a loan if your credit rating is too low. You will be instantly denied for the loan.
Business Credit Reports
Most business lenders require a copy of your business credit reports.
These reports tell lenders a lot of information about your business and particularly your payment history. Lenders can see how often you pay, whether or not you've been late making a payment, and much more.
Order a copy of your business credit reports first, before a lender sees it, to make sure your information is correct, up-to-date, and that nothing on your business credit reports would prevent you from getting a business loan.
Time in Business
Most lenders require a business to have some operating history. Traditional lenders will require a business to be in business for three years or longer.
Alternative lenders and online lenders generally require a business to be open for at least a year. Worth noting, some predatory lenders have no requirements on how long a business has been established. Also worth noting: some specialty lenders may not require a copy of your business reports so long as you can prove you have the sales to cover the cost of a loan.
The longer you are in business, the less of a risk you pose to lenders. The longer you're in business, the more likely your chances of being approved for a business loan.
Most lenders require business documents to approve a loan.
Some examples of these documents are balance sheets, cash flow statements, income statements, business bank account statements, trade agreements, and the like. It's important to have this information organized and easily accessible to lenders when applying for small business loans.
Collateral is anything of value that can be used to hold as value against a business loan. This includes personal vehicles, homes, and even retirement accounts. Business collateral are assets owned by the business.
This can include real estate, company vehicles, equipment, and even intangible assets such as stock. Most traditional lenders will require some collateral to secure a business loan. Depending on the collateral value of the collateral will determine how much loan you are approved for. Most lenders lend between 70% and 80% of the collateral value.
This means if you have a $10,000 car used as collateral. You may only be approved for a $7,000 loan.
How Does Business Loan Repayment Work?
When most people think of a business loan or any loan for that matter, the first thing that comes to mind is installment payments. This is not the only option for loan repayments, though.
There are three main repayment types:
Revolving payments are fairly standard with business credit cards and working capital loans.
The lender lends a line of credit to a business owner from which that business can draw funds off of on an as-needed basis. The business owner repays money back, including any interest, based on the money drawn from the loan.
For example, if you have a $10,000 line of working capital and you borrow $1000 from that line of credit. You only pay interest back on the thousand dollars, not the $10,000.
Installments are the most common business loan repayment type.
With installment loans, the lender disperses the full amount of the loan to the business owner, requiring the business owner to repay the loan plus interest and fees each month until the loan is repaid. With installment loans, it's important to note that these loans are divided equally over the term of the loan.
Installment loans may charge fees for early repayment. So be careful and know what the fees are before applying for an installment loan.
Cash Flow Payments
Cash flow repayment types require the lender to distribute the full amount of the loan to the business owner, but repayment is based on the business’s cash flow.
Examples of cash flow repayments include merchant cash advance loans and invoice financing. A merchant cash advance loan will provide a business with the money it needs upfront in exchange for a percentage of all future credit card sales. The payments are taken out daily and remain in effect until the loan, plus fees, have been paid in full.
How Small Business Loans Work by Type
There are many different types of business loans. This is where most business owners get confused. Selecting the right type of loan for your business is important and so taking the time to understand each of these loan types can save you a lot of money and frustration.
We recommend the following advice:
- Take your time going through each loan type listed below.
- Compare each loan type to your specific business needs.
- Understand the repayment types of each loan type and how it works.
- Decide the best loan type and focus on getting this type of loan.
Next Step: Apply for a business loan so you can grow your business.
The US Small Business Administration (SBA) exists to help small businesses and business startups get approved for business loans and business financing. This organization has designed several programs for business owners to take advantage of.
It's important to note that the SBA does not lend money, but guarantees the loan for lenders who do. The SBA takes risk off the table for the lender. With less risk, lenders are incentivized to loan money to businesses they might not otherwise approve.
Here is a list of some types of SBA loans you may want to investigate:
- SBA real estate loans
- SBA working capital loans
- SBA expansion loans
- SBA 7(a) loans
- SBA microloans
You can visit SBA.gov to learn more about how to get an SBA loan.
Business Line of Credit
Businesses most often apply for business lines of credit.
A business line of credit works much like a business credit card in that it's based on a revolving credit line. The lender extends a credit limit. The business owner then borrows against that line of credit.
The nice thing about this type of loan is the business owner only pays money on credit used, not the entire credit line.
Here are some things to understand about a business line of credit:
A business line of credit has two phases: a draw and repayment. It is important to know the difference between each phase. A business line of credit offers businesses lots of flexibility as it can be used to free up cash flow and take care of other essential business expenses.
- Draw phase: Regarding the draw phase, a business owner can use the money from the line of credit, repay it as they like, continue drawing on it again and again. During the draw period, the business owner is only required to make interest payments.
- Repayment phase: At some point, the draw will end, and the repayment period will begin. When the repayment begins, the existing loan balance will be amortized over a set period of time to be repaid in monthly installments by the borrower. It's important to note that during the repayment phase, no more draws are allowed.
Small Business Credit Cards
Small business credit cards offer small businesses lots of benefits. Like with a business line of credit, business credit cards operate on revolving credit lines. This means a business owner gets access to a certain amount of capital, drawn from the card, on an as-needed basis.
Here are some things to consider before applying for a business credit card:
- No set repayment terms. For businesses that maintain good credit and continue to repay the balance owed on the credit card each month, there really is no term set on when the debt has to be repaid. A business owner just makes the minimum monthly payment and continues doing so in perpetuity or until the business owner decides to pay the loan in full.
- Attached rewards. Businesses who qualify for a business credit card can gain access to many card benefits and rewards. Some business credit cards offer free travel insurance and rental car insurance. Business credit cards also offer cash back bonus awards, as well as other incentives just for using the business credit card.
- High-interest rates. A business credit card may come with rewards, but they generally come with a high-interest rate compared to other types of loans. It's important to understand what the annual percentage rate (APR) is on the card and how much interest you'll pay if you just pay the minimum payment due each month. Interest can compound and stack up, and before a business owner knows it, he or she can be in trouble. So be careful when using a business credit card. We recommend businesses pay their credit card balances in full each month.
Trade credit accounts are arrangements made with vendors and creditors. The business is free to purchase products from the vendor without having to pay immediately. In most cases, the period of time is 30 days before payment must be received. These types of accounts are known as net-30 vendor accounts.
Here's what you need to know about trade credit accounts:
- Your balance must be paid in full by the date on the invoice, preferably sooner. Since many net-30 vendors and creditors report trade lines to the business credit bureaus, you never want to miss a payment on a trade credit account. If you do, it can negatively impact your business credit rating and overall business credit score.
- No interest if paid on time. If you pay your invoices in full and on time, and hopefully early, there is no interest that you have to pay. This means you get the flexibility of getting the merchandise upfront, and you don't have to pay back the money until 30 days from the date of purchase. This advantageous for businesses operating on tight margins that need inventory in order to sell products to keep generating sales.
- Discounts for early repayment. Many net-30 vendors will extend special discounts when a business pays their invoices early. Many vendors also report early payments to the business credit bureaus, which help boost your business credit scores. This benefit alone is gold, as it can help businesses get access to higher lines of credit and future small business loans.
- Relationships matter. A strong relationship may be necessary before the vendor agrees to let the seller have a trade credit agreement with them.
- Only some vendors report to business credit bureaus. It's important to note that only some vendors and creditors report trade lines to business credit bureaus. Ideally, you want to do business with only vendors who report your timely payments to Dun & Bradstreet, Experian Business, and Equifax Small Business. This way, you boost your credit rating to be able to qualify for future business loans and higher credit increases.
Invoice financing consists of businesses putting up invoices, from their accounts receivables, as collateral for a loan. These types of invoice financing loans can be especially useful to businesses that act as vendors for other companies, offering net-30 accounts.
Here's what you need to know about invoice financing:
- Business owners use future account receivables as collateral to secure a business loan. Accounts receivables are money from invoices that are owed to the company. Once a trade partner pays the invoice, the business owner uses that money to repay the invoice financing loan.
- Invoice finance lenders allow businesses to borrow between 80% and 90% of the invoice amount, except in rare cases where a business may be able to borrow 100% of the invoice. However, most invoice financing companies qualify businesses for between 80% and 90% of the invoice amounts.
- Business owners repay only when the invoices have been paid. Once an invoice comes due and is finally repaid, the business then uses that repayment money to repay the invoice financing loan.
- Invoice financing is slightly different from invoice factoring. The main difference is that with invoice factoring, you actually sell the rights to your invoices to the factoring company, which then goes after the people who owe you money. With invoice factoring, the invoices are used as collateral to secure the loan, and generally, the factoring company charges more interest and fees for this type of loan arrangement.
Merchant Cash Advances
A merchant cash advance is a loan granted based on future merchant sales, specifically credit card sales. A merchant cash advance is a short-term loan that some business owners take out to alleviate pressure from their cash flow reserves. These types of loans help a business owner repay vendors on time, as well as process payroll.
Here's what you need to know about merchant cash advances:
- Easy to get. Merchant cash advances tend to be easy loans to get because they are approved based on recent credit card sales transactions. So long as a merchant can see that a business owner is raking in lots of credit card transactions each day, the merchant cash advance company will likely extend the loan to the business.
- Most expensive loan type. A merchant cash advance is not cheap. Usually, businesses opt for this type of loan when they need the money in a pinch. When you apply for a merchant cash advance, expect to pay more interest for the convenience of getting access to money now.
- Repayment is made through a percentage of future sales; rather than installments. With a merchant cash advance, businesses rely on future credit card sales to repay the merchant cash advance. The more credit card sales the business takes in, the less interest and faster the loan gets repaid. If you have some slow sales days, it can adversely affect your debt load.
- Requires a lot of credit card sales for approval. When applying for merchant cash advances, you'll need to show the cash advance lender that you have a steady flow of regular credit card sales. These types of loans are best for restaurants and retailers as they process a lot of credit card transactions daily.
Equipment financing loans are used by businesses to purchase equipment and tools to run the business. Equipment financing loans could be used to buy a fleet of cars or used to buy some technology to advance the company's goals.
Here's what you need to know about equipment financing loans:
- Great for purchasing equipment. As mentioned, equipment financing loans are great when companies want to purchase vehicles and other equipment to extend their business capabilities.
- An equipment loan is repaid in installments. This means all the money is disbursed to the company to make the purchase, then repaid over a fixed period of years in equal installments.
- Interest and fees are built into the monthly payment amount and spread over time.
- Easier to qualify for. An equipment financing loan is rather easy to qualify for because the equipment itself is used as collateral to guarantee the loan. If the business owner fails to make a payment at some point during the course of the loan, the finance company can take ownership of the equipment purchased by the business.
- Better interest rates. Because equipment financing loans pose little risk to the finance company, interest rates on these loans tend to be much lower than other loan types. This makes them very favorable to companies financing equipment.
- New business owners qualify. Because the risk is less, new business owners often get approved for these types of loans.
- Long-term loan commitment. Because equipment financing is considered a long-term loan commitment, businesses should consider this before applying for the loan. It's important for the business to understand that they will be responsible for repaying this debt.
Real Estate Loans
Just like individuals buy homes, businesses buy real estate too. A business owner may decide to take out a real estate loan to purchase a restaurant or other retail location.
Some business owners buy entire office complexes to operate their business out of, as well as rent out office space to other businesses. To purchase real estate requires a large outlay of capital. For this reason, real estate loans tend to be a long term capital investment.
Here's everything you need to know about real estate loans:
- Long-term loans. Not all, but most real estate loans have a term period of 30 years. A business has to factor this into the cost of the loan. If a business must pay a large percentage of its sales each month to repay the real estate loan, it may mean less access to money to do other things. It's best to do your due diligence and seek the help of an expert before purchasing real estate for your business.
- Low-interest rates. Most real estate loans have a small interest rate compared to other loan types. This makes them very attractive for business owners wanting to invest in real estate. Repaying the loans cost the business much less, and because the payments are spread out over 30 years, the payments can be relatively low.
- A long game for lenders. Lenders will require a business to have solid financials and a proven track record of sales growth before moving forward and approving a real estate loan. If you are a small business with a short track record of success, it may behoove you to wait before applying for a real estate loan. Once you build your business credit and prove that you can manage a business successfully, then you can apply.
How to Pick the Right Small Business Loan
As you discovered reading this article, there are numerous types of small business loans. You've also discovered that each business loan is different.
Here are some steps to consider when selecting the right business loan:
- Consider your business needs first. If you're a startup business, you're going to have different needs than if you're a seasoned business that has been around for many years. Every business has different needs. As a business owner, you need to find out what your needs are before you decide what type of business loan to apply for.
- Think about the payment type. Different lenders have different repayment plans, factor this in. When deciding which business loan to apply for, ask yourself if it's more advantageous for your business to apply for a revolving line of credit, or if it would be better to get a lump sum to purchase something like an office building. These are things you need to consider before applying for a business loan.
- Decide what type of payments make the most sense for your business. For some businesses, installment payments make the most sense. These are payments that are amortized over a set period of time and divided out and paid off in equal installments. Each month you will be required to make that payment until the term period is over. Only then will the loan be dissolved.
- Compare different lenders. Earlier, we mentioned that every lender is different. This is so true. When you factor what type of loan best fits your business, it is then time to look into the different types of companies that offer that specific loan type. As you do this research, make sure to choose a company that offers you the most favorable terms and the lowest rates.
Small Business Loans FAQ
How hard is it to get a small business loan?
The difficulty is determined by the type of loan you are seeking and the lender. For example, if you’re applying for a traditional term loan through a bank, you’ll likely be denied if you have no established business credit. If you’re applying for an online loan, they are not as strict on their requirements, and you may be able to qualify for a business loan. If you’re a new business or small business, we recommend applying for an SBA 7(a) loan. These are backed by the government, so they’re easier to qualify for when you’re trying to get funding for your small business.
Are business loans a good idea?
Taking out a business loan comes down to critical thinking and practical business sense. The main question to ask is whether this loan will improve your business’s bottom line. If you're unsure, take a second look. It's important to be confident when taking out a business loan and make sure it’s the right decision for your business.
What kind of credit score do you need to get a business loan?
The better your business credit score, the better your chances of being approved for a small business loan. The credit score you’ll need is ultimately up to the loan underwriter and the lending institution. On the low end, we recommend you have a minimum of a 680 credit score.
How do I get a business loan with bad credit?
- Know your credit scores
- Research your loan options
- Write a business plan
- Provide collateral
- Find a cosigner
What are the best loans for bad credit?
Read our full review of the best small business loans for bad credit.