A business loan is a financial asset that can help cover an unexpected expense, purchase expensive equipment, establish the groundwork for business expansion, or solve sudden cash flow problems. Seeking a business loan requires preparation and research, including determining the type of loan that is suitable and works best for you and your business.
Here’s what you need to know about various types of business loans and how to prepare to apply for one.
What types of business loans are available?
Choosing the type of loan that best suits your needs and repayment ability is essential. You should take out a loan with the idea that it will help your business, not saddle you with debt.
Line of credit loan
This short-term loan is considered a useful option for small businesses. With a line of credit, you’re given a certain amount of cash which you can draw from. You only repay the amount you draw and that’s the only amount you pay interest on.
Term loan
This type of loan is the one with which most people are familiar. Term loans come in both short- and long-term options, with generally lower interest rates for longer-term loans. Borrowers receive a lump sum of cash upfront and make monthly repayments of principal and interest. These loans have some of the lowest interest rates and generally require collateral.
Specialty financing
Specialty financing includes loans for very specific purchases, such as leasing or buying equipment. You usually pay equipment loans over the estimated lifespan of the equipment you’re financing, and the equipment serves as collateral. Specialty financing also includes commercial real estate loans. The main issue with these loans is that sometimes the loan outlasts the life of the equipment.
Invoice financing
With invoice financing, you use unpaid invoices as collateral to secure a cash advance, which is usually equal to a percentage of the invoice. You then repay the advance once the invoice is paid, along with a fee. A similar type of financing is invoice factoring, where you sell your outstanding invoices to a factoring company for it to collect on.
Merchant cash advance
Like a payday loan, a merchant cash advance is an expensive form of borrowing where you get a cash advance in exchange for a percentage of your future credit card sales. Because these loans are short, and repayment is taken out daily, they can have the equivalent of a 70–200% APR. The upside is that these loans are very quick and easy to obtain.
Personal loan
If you have a very strong personal credit score but have a new business or limited collateral, you might consider taking out a personal loan for business expenses. Keep in mind, though, that if you default on the loan, it will impact your personal credit.
Secured and unsecured loans
To receive a secured loan, you must provide collateral. The collateral, such as real estate or inventory, must outlast the loan. The advantage of a secured loan is that it usually has a lower interest rate than an unsecured loan.
Unsecured loans generally have a higher interest rate because the borrower does not have collateral to be claimed by the lender if the borrower defaults on the loan. You will only be able to receive this type of loan if the lender considers you to be low-risk. That generally means that your company has been profitable and the lender considers your business in sound condition.
How do Small Business Administration loans work?
The governmental body known as the Small Business Administration (SBA) doesn’t directly loan money to small business owners. Instead, it works with partner lenders to make it easier for small businesses to get loans.
The SBA guarantees a portion of the loan, meaning if the borrower defaults, and the lender can’t recoup its costs from the borrower, the SBA will pay that amount. This makes the loans slightly less risky for a lender, which in turn improves the likelihood of approval to a borrower it may not have otherwise approved.
SBA loans benefits
Loans guaranteed by the SBA offer a number of advantages, including competitive interest rates, making them a valuable resource for businesses that face challenges securing funding from traditional sources. Here are some other benefits of SBA loans:
- Flexible terms and repayment options. SBA loans offer longer terms—depending on usage, ranging from 10 to 25 years—than traditional business loans, allowing more time for repayment. They can also offer repayment flexibility, loan adjustments, and deferred payments, which traditional lenders can’t always provide.
- Resources and support. Some SBA loans include ongoing support and assistance with starting and running your business.
- Special advantages. Lower down payments, flexible overhead requirements, and no collateral requirements are some of the distinct benefits and advantages typical of SBA loans.
- Larger loan amounts and flexible usage. With the majority of non-SBA loan amounts being capped at $1 million, SBA loans can range from $500 to $5.5 million and can be utilized for just about any business necessity or purpose.
Types of SBA loans
There are several SBA loan types tailored to specific business needs. Here are three of the most common loans to consider:
- 7(a) loans. The 7(a) loan program provides loan guarantees to lenders to help give financial assistance to small businesses with special requirements. The maximum loan amount is $5 million and can be used for real estate acquisition, working capital, debt refinancing, machinery and furniture purchases, ownership changes, and multipurpose loans.
- 504 loans. The 504 loan program provides long-term, fixed-rate financing for major fixed assets, assisting in business growth and job creation. These loans are available through Certified Development Companies (CDCs), the SBA's community-based nonprofit partners. The maximum 504 loan amount is $5.5 million.
- Microloans. The microloan program provides up to $50,000 to small businesses and certain not-for-profit childcare centers. The loans, which average around $13,000, are administered by SBA-designated nonprofit community-based organizations with experience in lending, management, and technical assistance.
To apply for an SBA loan, you must provide a statement of purpose, a business plan, and financial statements, including a cash flow statement, income statement, balance sheet, and personal financial statement.
Once you’ve completed your loan application, review everything from a lender’s perspective to ensure you’ve provided everything they would want to see in order to approve your loan.
Steps to take before you apply for a business loan
Securing a loan may be just what your business needs, but proper planning is key to increasing your chances of approval. Here are steps to consider before applying:
1. Understand your options.
Applying with the right lender is as important as choosing the right business loan. When researching your loan options, look into banks and other lending institutions that offer business loans. While large banks can fund more significant loan amounts, alternative lenders may provide quick approvals and have less stringent funding requirements. Working with a local bank also allows you to develop a rapport with the lender. Having that personal connection can afford you more flexibility in the future.
[Read more: A Breakdown of Business Loan Types]
2. Build/maintain good credit.
One of the first things a lender will look at when determining whether to approve you for a loan is your credit score. Your credit score is a snapshot of your lending history, including how many lines of credit you have open, if you pay your bills on time, and if you’re using your current credit responsibly and effectively. Other factors lenders may consider when reviewing your business loan application include:
- Your experience in your industry.
- How long your company has been in business.
- Your company’s reputation with your customers and other industry competitors.
If your business is relatively new, a large bank is less likely to approve your business loan application, and alternative lenders and local banks may ask to see your personal credit score to help inform their decision. However, even if you don’t qualify for a business loan, you may be eligible for a business line of credit, which you can use to help build and improve your business credit score, helping you secure larger business loans in the future.
3. Prepare your documents.
Good financial records become especially important when applying for a business loan. Your bookkeeping and accounting processes should include tracking your assets, revenue, debt, and expenses. For a business loan, you’ll need to provide proof of cash flow and accurate financial projections. Lenders will want to see your financial reports and realistic forecasts with the loan factored in to accurately estimate your business’s future revenue and expenses.
Once you have your financial documents in order, you can determine how much you’ll need for your business loan. If your loan sum exceeds what you need, you could wind up paying unnecessary accumulated interest. On the other hand, if you request too little, you might need to apply for an additional loan, which will come with its own interest rate and payment plan.
When you have your loan estimate, review the potential loan terms against your business’s other financial obligations to determine what you can actually afford. If your loan estimate is more than you can afford, consider lowering your loan estimate or seeking a different loan option.
4. Follow best practices.
Making a mistake in the application process could prove costly for your financial future. Some best practices to keep in mind include:
- Think like a lender. Once you’ve completed your loan application, review everything from a lender’s perspective to ensure you’ve provided everything they would want to see in order to approve your loan. Your application is your chance to prove yourself a competent borrower.
- Be prompt and thorough. If a lender requires additional documentation, send it as soon as possible. Banks and lenders review many loan applications, and prolonging the application process may affect their decision to approve your loan. Provide more information than what the bank asks for if you can, so you can avoid delaying the process by having to provide additional documentation.
- Be accurate. Like applying for a job, padding your loan application may negatively affect your chances of getting a loan. Banks and lenders want to work with borrowers they can trust. So, review your financial documents carefully to ensure they accurately reflect your business’s finances, and its earnings and growth potential.
Is a loan your best option?
You need to decide if you really need a loan or if your main issue is related to cash flow. If cash flow is what’s causing the financial difficulties, you may be able to figure out a way to accelerate your receivables, even if that means offering customers a slight reduction in price for paying their bills early.
Decide if a loan will help you achieve the goals in your business plan. If you don’t already have a business plan, write one. A formal business plan will give you a better idea of what you need to accomplish with a potential loan and how large a loan you need. It’s an important step because most lenders will require a business plan if you decide to pursue a loan.
[Read more: How to Write a Business Plan]
Questions lenders may ask
When you apply for a business loan, lenders consider a variety of factors to determine your eligibility and ability to repay. Here are questions lenders typically ask businesses applying for a loan:
- How much money do you need? Lending money is a carefully considered business move, so lenders often ask about your financial needs, not your desired amount. Show and prove that you are borrowing only what you need to take the next step with your business.
- How do you plan to use the money? Lenders want responses that will show that their investment will increase your revenue—therefore, requests to repay old debts will likely be denied. Consider, and have a plan for, how you will use the money to build your business.
- How will you repay the loan? Lenders require assurance regarding loan repayment. They’ll want to view your assets, savings, and personal collateral to guarantee you can withstand business fluctuations while still repaying the loan under the agreed-upon terms. They may even request information about current or past loans, outstanding debts, and tax returns to assess your ability to repay.
- Will you be putting up any collateral? Collateral is a pledged asset used as security for a loan—if unable to repay the loan, your lender will take the collateral. A personal guarantee, which is not secured by an asset, may be required instead if a business defaults.
Borrower beware: predatory lending tactics to watch out for
As in any business transaction, you must be sure that you are being treated fairly. Watch out for these lending practices:
- Lenders who impose unfair terms on borrowers, either by deception or coercion.
- Interest rates that are significantly higher than those offered by competitors.
- Fees that are more than 5% of the value of the loan.
- Being asked to lie on the paperwork.
- Being told to leave signature boxes blank.
- Being pressured into taking a loan.
Before finalizing a loan agreement, consult an attorney, financial planner, or accountant to determine when you need the money and how much you need.
Business loans alternatives
If a traditional business loan isn’t the right fit for your needs, there are several financing alternatives. Depending on your situation, here are a few options to consider
- Crowdfunding. When businesses use small amounts of funds from a large number of investors, leveraging social media platforms and sites like GoFundMe and Kickstarter, it is called crowdfunding. This option allows owners to raise large amounts of money quickly and generate revenue from a percentage of the funds made.
- Bootstrapping. Bootstrapping is when a business is built and funded by personal finances or operating revenue rather than outside investors, giving the business owner complete control. Unlike the “all or nothing” nature of crowdfunding, bootstrapping does not require a ready-made product, allowing businesses to develop and grow at their own pace.
- Equity financing. Equity financing is the process of raising funds for short-term necessities such as bills or long-term projects by selling shares of the company—to friends, family, investors, or through a public offering—in return for cash.
- Grants. Grants differ from loans in terms of repayment and require businesses to qualify through an application process. With a grant, the business agrees to spend the funds as specified by the grantee, and the funds are not required to be repaid unless grant terms are violated.
[Read more: Equity vs. Debt Financing: What’s Best for Your Business Goals?]
Julianna Lopez contributed to this article.
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