You’ve started your own business and are looking for financing options. Congrats! The world of business loans can be confusing to first-time borrowers, so read on to learn more about what a small business loan is and how it works.
What is a business loan?
A business loan is a financing agreement between a business and a lender. Like any loan, a business loan will provide the company with a designated amount of money to be repaid over a certain period.
You may receive a lump sum of cash to use as working capital or to purchase equipment or inventory, or you may gain access to credit to make purchases as needed.
Common reasons to get a business loan include:
- Cover everyday expenses
- Purchase property
- Purchase business equipment
- Launch a new product or service
Business loans can be unsecured or secured. An unsecured business loan does not require you to pledge any assets to use as collateral, although you may be required to sign a personal guarantee. With a secured loan, you must pledge assets equal in value to the loan amount. Common examples of business collateral include inventory, real estate, and equipment.
There are many different types of financing options for your business, so it’s smart to understand how each one works and which is best for your needs. While banks and credit unions are common commercial lenders, you can also apply for business loans from alternative financiers, many of which you can find online.
How do business loans work?
While the process may vary slightly depending on the loan type and lender, the loan process generally follows these steps.
1. Research and gather documents
Before applying for any loan, you should thoroughly research your options and compare loan terms. With online platforms like Lendio, you can look at multiple options within minutes for free. You will also want to start gathering the required documents.
2. Application and financier decision
After you know what business loan you want, fill out the application. In some cases, you might be interviewed in person or by phone by a representative of the lender. Once you submit an application, you must wait for an approval decision. This can take a few days to several weeks. If the lender deems your business creditworthy, you will be approved.
3. Disbursement
Typically, you will receive the total loan amount at once, either as a check or funds deposited in your account. Depending on your loan agreement and the type of loan you received, you can either use the money for any business expense or use the cash to make a designated purchase, such as land or equipment.
4. Repayment
You will pay the lender back for the total amount of the loan, as well as interest and any fees. You will usually make repayments until the loan “matures,” meaning you reach the end of the agreed-upon repayment period. This might be as short as a few months in the case of short-term loans, or it might be 15 years if you accept certain term loans.
Types of business loans.
Several different types of business loans may suit your business. It’s highly recommended that you explore some of the most common financing structures to see which could be an option, including the following.
Term loan
A term loan is a fixed sum the lender dispurses upfront. The borrower then repays the loan in fixed amounts along with interest every month. Interest rates for term loans can be fixed or variable.
Generally, small business term loans are for large amounts (up to $2 million or more) and have repayment periods spanning several years, up to 10 or 25 years. Because of this, financiers usually have stricter thresholds for approval compared to some alternative forms of financing.
Business line of credit
Instead of a lump sum of cash, a business line of credit gives you access to a credit line you draw from at your own pace. You only pay interest on your outstanding balance, and your available credit replenishes as you make payments. This could be a good option for financing inventory purchases, ensuring smooth payroll, or getting your business through seasonal slow periods.
There’s usually a time limit for how long you can access your line of credit, but many lenders allow you to renew the term if your account is in good standing.
SBA loan
SBA loans are offered through approved SBA lenders and backed by the U.S. Small Business Administration. You can borrow larger amounts, enjoy longer repayment terms, and get lower interest rates. The downside is that the application process can be cumbersome and take a long time.
SBA 7(a) loans are the most common SBA loan type because the funds can be used for general purposes. SBA 504 loans are used to purchase property or equipment. An SBA Microloan is for smaller amounts and is administered by a nonprofit lender.
Business cash advance
A business cash advance allows you to borrow money based on expected revenue. The advance is repaid by taking a percentage of your daily or weekly sales through a bank account withdrawal. A fee is added to your balance, and you’re typically given a repayment term of 3 months up to 2 years.
It can be an expensive type of financing and eat into your profit margins and cash flow. As you’re considering this option, gauge your business’s ability to generate regular sales.
Equipment financing
Equipment financing is used to pay for any kind of business equipment you need for your company. It could be used for anything from restaurant equipment to a company car or even office furniture. Equipment financing is an attractive option to many business owners because the purchased equipment is usually used as collateral for the loan. Once you pay off the balance, you own the equipment in full.
Loan amounts are high with equipment financing, with the upper limit at $5 million. Interest rates can also be lower compared to other business loan options since the equipment loan has collateral to go with it.
Common features of a business loan.
When comparing different types of business loans, keep an eye out for each of these features:
- Loan amount: Different lenders may offer you a different loan amount.
- Interest rate: Check the interest rate on every loan offer, so you know exactly how much your financing will cost.
- Lender fees: In addition to interest, some lenders may charge origination fees, prepayment penalties, and more. Read the fine print of each offer so you don’t owe more than you expected.
- Repayment term: Repayment terms can last from a few months to several years. A loan with a lower interest rate could cost more in the long run if there is a long repayment term.
- Payment frequency: Are payments due daily, weekly, or monthly? Your repayment schedule is typically tied to the level of risk of the loan.
Business loan requirements.
How hard is it to get a business loan? Lenders typically look at three primary factors when determining eligibility.
Credit score: Even though you’re applying for a business loan, lenders still check the personal credit score of the owner. Anything above 700 is considered good, but you may still qualify with a score in the 500s or 600s depending on the loan type.
Time in business: Each lender has its requirements for the amount of time you’ve been in business. Traditional banks and SBA lenders usually require a minimum of two years. However, some online lenders may approve businesses that have been around for three to six months.
Business revenue: Revenue requirements vary depending on the lender and how much money you want to borrow.
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Information provided on this blog is for educational purposes only, and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strives to keep its content up-to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.
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