The right type of small business loan may be all you need to launch a new venture or grow an existing business, but deciding what kind of loan is right for you isn't always a simple task. Understanding how business loans work and what options are available to you will help you determine which one you should pursue to get the working capital you need.
What is a small business loan?
Put simply, a small business loan is a type of financing offered to a company by a lender or provider. In exchange for capital, lenders charge interest and fees and require businesses to repay the principal on a set schedule over a standard period of time. However, repayment terms, interest rates and fees vary greatly depending on the type of business loan you take, who the lender is and various other criteria, such as your credit history, years in business and existing debt.
What to consider before applying for a business loan
What you need a loan for
Before applying for a business loan, you need to prepare a detailed business plan that explains how you will use extra capital to fund your business. Identify your specific business goals for the money, such as expanding into new markets, improving a product or service, growing your team, opening a new location, or simply having a safety cushion.
When to apply for a loan
The best time to apply for a business loan is when your company needs capital and, more importantly, you meet or exceed the minimum qualification. Lenders generally consider the following criteria:
- Credit score: First and foremost, lenders will evaluate your business and personal credit history and determine your level of risk. Lenders look for borrowers with a credit score above 680, though the exact minimum score is based on various other factors, such as your industry and the current economic trend.
- Years in business: Most lenders require borrowers to have been in business for at least one year. Depending on the lender, the type of loan and the amount you want to borrow, you may need to have been in business for at least two years to qualify for a small business loan.
- Annual revenue: Most traditional lenders require you to have a minimum annual revenue, usually between $50,000 and $250,000. Microlenders, on the other hand, may offer short-term loans as low as $2,500. Before applying for a loan with any lender, make sure your business exceeds their revenue threshold.
- Ability to make payments: Finally, lenders will consider your ability to make payments. Carefully go over your business financials and make sure you have enough cash flow to make your repayments on time.
Amount of money you need
When you meet with potential lenders, make sure you have a specific amount of money you'd like to borrow. Make sure this number reflects the real amount you need to achieve your goals and that you have the ability to pay it off.
Types of lenders
When most people think of a lender, they think of traditional types, such as banks, credit unions and financial companies. However, there are other types of business financing that you can use to fund your business, such as these alternative lenders:
As you weigh different lending options, consider each institution's loan terms, or the total amount of time the loan will last if you make the minimum payment each month. Also, look for any additional terms and conditions listed under the loan terms. Loan terms vary by the type of lender and loan, from a few months to several years.
In most cases, you are expected to pay back a business loan over the term of the loan with a regular monthly payment. The amount you pay with each installment depends on the amount you borrowed, the type of loan and lender, your credit history, etc. Failure to repay a loan is known as a default, and it can have steep consequences for a business's creditworthiness.
With a traditional business loan, the lender provides capital to a business, and the business repays the amount borrowed, with interest, over the loan term. Interest rates constantly fluctuate depending on the current economy, and they also depend on the type of loan you want, the type of lender, and qualifying factors such as your credit history.
Types of small business loans
There are many different types of loans and lenders, and deciphering the differences between them can be tricky. If you're considering a loan and you don't know where to start, this guide will help you determine what type of small business loan is right for you.
Small business line of credit
A business line of credit is a common financing option for small businesses that works kind of like a credit card. You can borrow money up to a certain amount and pay interest on the funds you borrow. As long as you don't go over your credit limit, you can borrow funds and repay as often as you need.
A line of credit is ideal for businesses that require short-term capital to take advantage of a growth opportunity, bridge a gap, offset seasonal fluctuations in cash flow or meet an unexpected need.
Invoice factoring (or invoice financing)
Invoice factoring (also known as accounts receivable financing, invoice financing or factoring) is the process of selling your outstanding invoices to a lender, also known as a factor, in exchange for an immediate advance on the money your clients and customers already owe you. Companies often use factoring to improve their cash flow and secure funds on invoices.
Factoring invoices is ideal for businesses with longer receivable payment terms, usually between 30 and 60 days. If you would like to improve your company's cash flow, factoring is a good method to receive your money faster.
An asset-based loan is designed to help businesses secure financing based on collateral, such as inventory or accounts receivable. These loans are generally easier to qualify for, and businesses gain quick access to capital to reduce or eliminate short-term financial needs.
This type of loan is ideal for companies that need capital to keep normal business activities running and can use their own assets as collateral.
Depending on the business, equipment can be prohibitively expensive. If it is reasonable to take out a loan for a car, it can be equally reasonable to take out a loan for specialized equipment that costs tens of thousands of dollars. Equipment financing loans will be treated much the same as any other: Your credit will be reviewed along with your assets and cash flow to determine a reasonable loan amount and rate.
As the name indicates, microloans are small loans. Typically, they are for $50,000 or less. For some small businesses, that seems like a lot of money, but microloans can be as small as needed. The purpose of these loans is to jump-start a business, which can include acquiring inventory or raw materials, making down payments on larger investments, and a number of other uses for the money. Microloans usually have low interest rates, but they also have short repayment terms.
Small business term loans
A small business term loan is a type of short-term financing that is usually intended to fill one specific need to help your business grow. For example, if you need to upgrade your equipment, hire additional employees or expand to a new location, a term loan can bridge the financial gap to get you there. As the name suggests, this type of loan has a fixed term, ranging from a few months to several years.
This type of loan is ideal for business owners who need upfront cash to fill a financial gap to complete a specific task, such as hiring seasonal staff or opening a new location.
Merchant cash advance
Also known as a business cash advance, this type of loan is funded from a provider based on a business's future credit card sales. You are required to repay the advance with interest based on a percentage of your credit card sales until it is paid in full. Because a merchant cash advance is paid through a percentage of your credit card receivables, there is no set payment term. Rather, your ability to repay the advance depends on how many credit card sales you make.
A merchant cash advance is ideal for businesses that rely heavily on credit card transactions, such as retail storefronts and restaurants. This type of loan also doesn't require you to have an excellent credit score or make manual payments to repay the advance.
An SBA loan can be used for virtually any purpose. It's a long-term, low-interest small business loan that is partially guaranteed by the government, specifically the U.S. Small Business Administration. While the SBA does not loan the money itself, it does reduce the risk for the lender. SBA loans are sometimes more difficult to qualify for than other types of loans, and if a business does qualify, it can take several weeks to go through the approval process and receive funds.
An SBA loan is ideal for small businesses that have been in business for at least two years, have a good credit score and have exhausted other financing options.
Business loan options and practices to avoid
While traditional lenders tend to have strict requirements and can be difficult to qualify for, they are established and trusted entities that ultimately want your business venture to succeed. In many cases, if your business qualifies for a traditional loan, it makes sense to choose this funding method.
If your business does not qualify with a traditional lender, alternative lenders and clever financing options can fund your business, but you have to be careful. Here are some alternative financing options and what to avoid:
- Business credit cards: There are many reasons why your business should get a credit card, so long as you use it properly and sparingly. A business credit card can help you build business credit and doesn't require collateral (something new or young businesses may not have). However, if you use it incorrectly, you can hurt your credit score and quickly accrue more debt – and fees – than you can afford. A business credit card can help your business grow, but it can also sink it.
- Invoice factoring: Like a business credit card, invoice factoring is a great solution for certain businesses in specific situations. Factoring has many benefits – it has a fast application process, it mitigates cash flow problems, and factoring companies can even help you with the collections process. However, interest fees can add up quickly, and if a customer doesn't pay, you may be on the hook to repay the advance.
- Merchant cash advance:If your business receives regular payment through credit cards (such as if you run a restaurant), a merchant cash advance can provide you with fast funding with no monthly installments or collateral, even if you don't have a solid credit score. However, merchant cash advances are one of the most expensive forms of business financing; you'll probably save money with a different lending source.
Small business loan requirements
Regardless of which business loan you pursue, the requirements to qualify and get approved are often similar. Here are some of the requirements you can expect.
Personal and business credit scores
If your business has a credit history, some types of loans will require lenders to run a credit check on the business. If your business has an excellent credit history, you will have an easier time getting approved. Additionally, the cost of borrowing money will be lower, and your likelihood of securing favorable repayment terms will increase.
If your business doesn't have a credit history, lenders will check your personal credit score and secure a personal guarantee that you will pay back the debt with your personal assets if the business fails to make a payment.
Often, the best way to secure a loan is to build a strong personal and business credit score. Many lenders will take both into account when determining whether to extend financing to your business and on what terms.
In addition to your credit score, lenders will look at your credit reports to see if you have any missed payments, bankruptcies, foreclosures or accounts in collections. If your credit score isn't as high as you'd like but your credit report doesn't have any red flags, you may still be able to secure a loan.
Time in business
Many lenders are cautious about providing certain types of loans to newer businesses, as they don't have an indicator of how risky their investment in the young business will be. Many types of business loans, such as SBA loans and business lines of credit, require a company to have been in business for at least two years. Other types of financing, such as merchant cash advances and invoice factoring, are more available to younger businesses.
Business finances and collateral
Many lenders require detailed information about your financial situation and will ask for cash flow statements, profit and loss statements, future projections, and other financial statements. The stronger your business finances are, the more likely you are to be approved for a business loan.
Many types of hard money business loans require collateral, especially if the lender determines the business is risky. A lender will usually look for a physical asset as collateral, such as equipment, inventory or real estate.
Cash flow and annual revenue
Lenders will look at your annual revenue and cash flow to determine whether you will be able to repay a loan on time. Even if you have an excellent credit score and have been in business for several years, if a lender doesn't think you can afford the repayment terms, they won't provide capital.
Finally, business lenders will consider how much money you are asking for and determine the risk. If you are a new business or have a subpar credit score, you may be approved for much less than what you hoped for. However, getting your foot in the door with a smaller loan is often an excellent opportunity to prove your creditworthiness and build a strong relationship with the lender.
Generally speaking, you don't have to worry about asking for more than what you actually qualify for. Business lenders want to work with companies, so they will often provide a counteroffer for a smaller amount to do business with you. Keep your expectations reasonable, but don't stress about asking for too much.
Secured vs. unsecured business loans
A secured business loan uses assets as collateral. If you are starting up a business, you could put a lien against your house, for example, to secure the loan that gets your business off the ground. In general, secured loans are more favorable because the lender is taking on less risk. When you have sufficient collateral to qualify for a secured loan, taking on that extra risk yourself is a great way to convince lenders or investors to jump in, and it can get your business going faster.
Unsecured loans have no collateral. This makes them much riskier for a lender, and that changes a few things about the loan. For one thing, unsecured loans are more likely to be denied. If a lender sees too much risk, they will not get involved. If the loan is granted, it will almost certainly have a higher interest rate. Despite that, unsecured loans can be the best option for an entrepreneur in many scenarios – mainly because they do not put your livelihood or financial security at direct risk. [You can read more about secured vs. unsecured business loans here.]
How to apply for a business loan
Applying for a business loan is a daunting prospect, but it can be very straightforward if you have all the proper documents prepared and you apply when your business qualifies for the loan.
What documents do you need?
The specific documents you need for a loan depend on the type of loan and the specific lender, but these are the most common forms you'll generally need:
- Business plan: Many lenders don't require a copy of your business plan, but it's still best practice to have a detailed business plan ready. The business plan should include your plans to borrow a specific amount of money, how it will be used and how you will repay the loan.
- Bank and financial statements: One of the most important sets of documents to prepare for a lender is your bank and financial statements. Lenders want to know how much money is deposited and withdrawn from your bank account each month and how your money is being used. Your financial statements should include your balance sheet, profit and loss statement, cash flow statement, and any other specific form they ask for.
- Tax returns: For pass-through entities, such as sole proprietorships and partnerships, you will need to provide your personal tax returns. If your business files a tax return, you will have to provide this return as well.
- Employer Identification Number: Your EIN is a nine-digit number assigned to you by the IRS, also known as a Federal Employer Identification Number or Federal Tax Identification Number. Many banks require an EIN to open a business bank account.
- Proof of collateral: If you have to provide collateral to secure a loan, you will need to provide proof that you own something of sufficient value, such as real estate, inventory or equipment.
Submitting a loan application
Once you have gathered all the required forms and documents, you may be tempted to apply for and submit several loan applications at the same time. However, it's best to choose your lender carefully and submit one application at a time. As with a personal loan, submitting several business loan applications at the same time can have a negative impact on your credit score.
How to increase the odds of a small business loan approval
Getting approved for a small business loan is difficult but achievable. Here are a couple of basic steps to improve your chances of receiving a business loan.
1. Improve your credit score.
While not every loan involves an extensive credit check, many do. The best and most likely way to get approved for a business loan is to diligently improve your credit. Bad credit makes it harder to secure a loan and then makes borrowing money more expensive when you reach that point. Make sure your business is registered with the three big business credit reporting agencies – Dun & Bradstreet, Experian, and Equifax – on their respective websites to officially establish and track your business credit.
If you apply for a certain amount and the lender gives you a lower counteroffer, consider taking the offer to establish a relationship with the lender. Be prudent with any business credit card or line of credit expenses, and pay off any debt as quickly as possible.
2. Provide a personal financial summary.
Before you speak with a lender, prepare documentation of all your personal financials, including all assets that may be used as collateral, such as real estate, vehicles and investments. Also make sure to prove all information regarding liabilities, such as mortgages, loans and credit card debt. Be as upfront as possible about your liabilities.
Getting approved for a small business loan takes time and research. Before you pursue a loan, make sure you have a strong understanding of your business, your industry and what type of financing you qualify for.