Applying for a small business loan can be a challenging process. Not only is it important to organize your documentation, but you must also give the lender significant transparency into your business. After that, waiting to find out whether you've been approved or denied for the loan can be nerve-wracking.
But exactly how hard is it to get a small business loan? The answer might depend as much on the lender as it does on your own financial circumstances.
How does a small business loan work?
A small business loan can encompass a variety of products, but it most commonly describes a term loan from a financial institution, such as a bank or credit union. A term loan is one of the most affordable funding options available to entrepreneurs, but it requires substantial documentation and good personal and/or business finances. The upside is that a term loan tends to be a low-interest loan from a trusted lending institution.
The cost of a small business loan
Small business loans often range in term from one to five years, though they can be longer in certain cases. They could be microloans of a few thousand dollars or much more substantial, surpassing $1 million. Generally, small business loan interest rates range from 2% to 8%, depending on the lender's requirements and the borrower's creditworthiness.
Beyond the interest rate, most lenders charge other fees, such as these:
- Application fee
- Origination fee
- Monthly and/or annual maintenance fee
- Late payment fee
- Prepayment penalties
Loan terms
The terms on a small business loan will vary depending on the lender. Some lenders offer only short-term loans of no more than 24 months, while others will let you repay loans for many years. When determining which loan is right for you, consider why you are borrowing the money and how far in the future the payback is. You don't want to end up paying back a loan on something that lost its value long ago.
In our review of Fora Financial, we found that it's a good option for short-term loans. Borrowers may do better with a loan from the U.S. Small Business Administration (SBA) if they want to pay it back over an extended period of time.
Loan structure
Here's an example of the structure of a typical small business loan:
- A lender approves a borrower's loan request for $10,000.
- The term of the loan is one year.
- The annual percentage rate (APR) on the loan is 10%.
- The borrower must pay back the principal amount of $10,000, plus approximately $550 in total interest, over the life of the loan.
- The loan will be repaid in 12 monthly installments of about $880.
This is a highly simplified example of a small business loan, but the general structure applies to all term loans. When you sign a loan agreement, pay close attention to the terms and restrictions, such as loan covenants that could trigger a default if violated. However, the bare bones of a business loan will appear similar to the above.
Another common small business loan is the SBA's 7(a) loan program. While many small business loans require a personal guarantee from the borrower, with this program, the SBA guarantees the loan. This expands the opportunity to secure funding to borrowers who would otherwise be denied for a loan. However, it takes longer to secure funding through the SBA 7(a) loan program. Generally, SBA loans range in value from $500 to $5.5 million.
Editor's note: Looking for a small business loan? Fill out the questionnaire below to have our vendor partners contact you about your needs.
How do you qualify for a small business loan?
Qualifying for a small business loan is the first step to secure funding to start or grow your business. Lenders are primarily interested in one major thing: your ability to repay the loan with interest on time. Demonstrating your ability to do so is the most important aspect of qualifying for a small business loan.
Lenders look at many factors when underwriting your loan. These are some of them:
Cash flow
Lenders want to ensure you can make your monthly payments, so they look at how well you manage cash flow. They want to make sure more money is coming in than going out.
"Be ready to show a history of steady, strong cash flow or a business plan with a strong likelihood of sufficient cash flow to repay the debt," said Rob Stephens, founder of CFO Perspective.
Credit score
Your credit score dictates whether you'll be approved for the loan and at what interest rate. The better your credit score is, the less interest you'll pay. The worse it is, the more it will cost to borrow money. Stephens said a healthy credit score – both personal credit and business credit scores – improves your odds of qualifying for a small business loan. Lenders will likely pull your credit report when you apply for a loan, which could help or harm your chances of approval.
"Maintain a good personal credit score," Stephens said. "Banks will require a personal guarantee on the debt, so good personal finances improve the odds of getting a loan. You may also need to pledge collateral or find other guarantors for the loan."
Debt-to-income ratio
Lenders often also look at the debt-to-income ratio, a measurement of how much money you are bringing in versus how much money you owe. Your debt-to-income ratio demonstrates how leveraged your business currently is, so a lower ratio suggests your business has a better ability to repay additional financing.
Of course, a lender isn't going to simply take your word for it and hand you the money. They'll need supporting documentation that shows you are truly in a position to repay the loan you are requesting. So what should you bring with you?
What documentation do you need for a business loan application?
Every loan application will require documentation to back up your assertions. It's important to bring any corroborating documentation you have that demonstrates your business's financials and history to the lender.
"To apply for a conventional small business loan, you'll first need to share all of your financial details, including your personal financial information, your future growth plans, and precisely how you'll use the requested capital," said Farhan Ahmad, founder and CEO of Bento for Business.
Ahmad said it's important to be prepared when filling out a loan application. He recommends bringing the following documentation with you:
- Employer identification number
- Business permits and licenses
- Personal and business tax returns for the past three years
- Any bankruptcies or bounced checks
- Personal and business credit scores
- Annual profit and revenue
- Statement of disclosure of debt
- Copies of commercial leases
- Personal and business bank statements
"Some applications will require even more information," Ahmad said. "Generally speaking, low-cost, long-term loans have more paperwork than high-cost, short-term ones."
How long does it take for a small business loan to get approved?
Once you've filled out your application and submitted your documentation, the lender will consider you for approval. Depending on the lender, you might have to do a bit of waiting. The lender will examine your financial statements – including your annual revenue, tax returns and existing loan balances – to determine whether your business can financially support new debt. They will also consider your credit history and ensure you meet their minimum credit score, a threshold that varies by lender. All of this can take some time.
"If you're applying through a bank, you'll then need to pay the application fee and wait for a period of two to four weeks to see if you've been approved," Ahmad said. "This might seem like a long time, but loans through the Small Business Administration can take even longer to get approved – sometimes 90 days or longer."
Alternative lenders are much quicker to approve and fund small business loans. In our review of Rapid Finance, we found that business owners can receive funds the same day they are approved.
For businesses that don't have much of a history, securing a small business term loan can be difficult. Lenders often base their decisions largely on track record, so without much of a financial past to examine, newer small businesses are in a difficult spot. However, strong personal finances, personal guarantees and the right collateral can increase your chances of securing a loan. Of course, that puts additional pressure on your business to successfully repay the loan plus interest.
How do you make sure a small business loan is right for you?
In some cases, small business owners are so eager for funding that they accept a loan that isn't suitable for their needs. Before applying for a loan, you should understand why you need it and how much funding you require. Loans are important tools in the entrepreneur's arsenal, but if they aren't managed wisely and strategically, they could become an undue financial burden. Take the steps to ensure a small business loan is right for you by asking yourself these questions:
Why are you borrowing money?
It's important to understand why you are borrowing money before you can select the correct loan product. "Is it for day-to-day expenses like inventory and employee salaries?" Ahmad said. "Are you a first-time entrepreneur in your first year of business, in need of a startup business loan? Are you hoping to expand your business, perhaps by adding another location? Or do you just need a safety cushion?"
What type of loan meets your needs?
Once you know why you are borrowing money, you can determine which loan is right for you. "For example, for day-to-day expenses, you might need a smaller loan with a longer repayment period, but for expansion, you might require a larger loan with a shorter repayment period," Ahmad said.
Can you meet your loan obligations?
Of course, the other consideration that should be top of mind is how you will pay back any loan you accept. Small businesses that don't have a repayment strategy based on their true financial metrics could run into debt trouble.
"To make sure you're able to pay back a loan on time, I recommend setting up an airtight budget for business expenses," Ahmad said. "If you keep close track of how much money you'll need each month for all of your expenses – from inventory to paychecks to electrical bills – you'll be better prepared to set aside the requisite repayment amount each month, and therefore more likely to pay it back on time."
If you are forced to make a late payment, he added, it is beneficial to know the details of your lender's late payment policy.
Is an alternative loan right for me?
If you need funding more quickly than the weeks or months a conventional loan takes, there are other options. However, most of the alternative lenders that provide fast approval and funding charge higher rates. Small business owners considering working with an alternative lender should balance the importance of speed versus cost.
Alternative lenders come in many varieties; many offer multiple products, such as bridge loans, invoice factoring and cash advances. It's important to understand the ins and outs of each financing type before you decide which method of funding is right for your business.
Alternative lenders, sometimes called online lenders, generally offer a simple application process for flexible loans. They also generally have a faster turnaround than banks and credit unions, as well as more latitude when it comes to application approval. The drawbacks are that alternative loans are generally more expensive. They also tend to be short-term loans, meaning you'll likely have to pay higher installments than you would with a conventional bank loan.
How to choose the right type of business loan
Choosing the right type of business loan is critical, both for you and the long-term viability of your business. Although you must first consider eligibility requirements, this should not be the only determinant. The loan you select should also have repayment terms that work best for you and your company. For instance, short-term loans or merchant cash advances are not usually good choices for recently launched businesses, since they ask for quick repayment.
Here are the top types of loans available to small businesses, along with the standard qualifications.
Bank loans (SBA loans)
- Collateral requirement
- Good credit requirement
- Longer turnaround for funding
- APR fixed by the government
Most organizations turn to traditional loans and SBA loans before considering alternative lending sources. If you have good credit and proven assets, traditional loans provide key benefits. Most notably, bank loans funded through the SBA have competitive interest rates. According to the SBA, interest rates range from 5.5% to 8%. These long-term financing solutions provide lending up to $5 million.
Online lenders
- Variable APR
- Less stringent credit requirements
- Lower maximum loan amounts
- Quicker loan processing
If you can't get approved by a traditional bank or need funding sooner, online lenders could be a solid option for organizations. Online loan companies are ideal for companies searching for quick approval and loan processing. Online lenders also provide a solution for those with less than stellar credit histories. Standard APRs are likely to be more than traditional loans, but the organization may not require any collateral. Application processing and approvals are faster with online lenders than with traditional banks, which is important if you need to improve cash flow quickly.
Alternative loans
- Stricter loan terms
- Short repayment schedules
- Fast loan processing
- Flexible credit requirements
Alternative lending opportunities have grown in popularity over the last 15 years. Alternative lending providers include peer-to-peer (P2P) loans, merchant cash advances and invoice factoring. A P2P loan is an unsecured loan with a fixed interest rate. These loans are meant to provide short-term funds with average repayments made between two and four years.
The benefits of P2P loans include no application fees, fast processing and flexibility with credit scores. Merchant cash advances are lending programs intended for organizations with a high amount of credit card transactions. The cash advances are very short term, with repayment completed in less than three months.
To pay back the loan, a percentage of your daily credit card transactions are paid directly to the credit card provider. For instance, if you make $350 in daily sales and your lending term is to pay 10% of daily sales, the lender would take $35.
Invoice factoring is a lending program that allows you to be paid upfront for any unpaid invoices. The lender pays you for the invoices and takes a percentage. Repayment is usually done in full within three months after the invoices are paid by clients.
Microloans
- Short-term lending
- Collateral required
- Good credit needed
- Competitive interest rate
Microloans are lending programs through the SBA, but with different loan options. Most notably, microloans are for small funding amounts. According to the SBA, the average microloan amount is around $13,000. The program specifies what the funds can be used for, including supply inventory, working capital, machinery and equipment purchases and rentals, and furniture for the business. Microloans provide a low APR, but you will need a solid credit history and to put up some form of collateral. Accion, one of the lenders we reviewed, offers microloans starting at $500.
A matter of demonstrating reliability
If you need a small business loan and have good personal and business credit scores, thorough financial documentation, a history of strong cash flow, and a manageable debt-to-income ratio, you should have little trouble getting approved. For businesses lacking in any of these areas, it might be more challenging to secure a small business loan, but with the right documentation and guarantees, it is still possible.
If you find yourself in a position where it's not likely you will secure a conventional small business loan, consider an alternative lender. However, alternative lenders typically charge much higher rates, so ask yourself if it's really necessary before you take out a loan.
Securing any loan is a matter of demonstrating reliability to the lender. If you can show you have the ability to pay back your loan with interest in the allotted time frame, your application will likely be approved on the first pass.
Adam Uzialko contributed to the writing and reporting in this article. Some source interviews were conducted for a previous version of this article.