How Do Business Loans Work?

Small businesses account for nearly half of the private workforce in the United States, creating two out of every three new jobs.

 As a small business owner, securing a business loan may provide the financial boost needed to launch or expand your business, purchase essential equipment, or manage working capital. Knowing how the best business loans work helps you find the right loan for your needs and make informed decisions.

What Is a Business Loan?

A business loan is a form of financing available to qualified businesses through traditional banks, online lenders, and credit unions. These funds can cover operational and growth costs, such as working capital, equipment purchases, or real estate.

How Do Business Loans Work?

Business loans provide funds either as a lump sum or a credit line. In return, your business repays the loan over time with interest and fees. Repayment schedules may be daily, weekly, or monthly, depending on the loan type.

Business loans are categorized as either secured or unsecured. Secured loans require collateral, such as real estate, equipment, or investments, which the lender can claim if the loan goes unpaid. Unsecured loans do not require collateral, but they often require a personal guarantee, meaning you accept personal liability if the business fails to repay the loan.

Common Uses for Business Loans

Business loans serve various purposes, though you’ll need to explain your intended use when applying for financing. Common reasons for obtaining a loan include:

• Startup costs

• Commercial real estate purchases or renovations

• Cash flow management

• Debt consolidation or refinancing

• Equipment and inventory purchases

• Business expansion or franchising

• Marketing and advertising

However, loans cannot be used for personal expenses like home purchases or vehicles unrelated to business activities.

Types of Business Loans

Several types of business loans are available, each offering unique terms and requirements. Here are some options to consider:

SBA Loan

An SBA loan is backed by the U.S. Small Business Administration, which guarantees a portion of the loan, reducing the risk for lenders. These loans often range from $30,000 to $5 million, with terms as long as 25 years. While interest rates can be competitive, the approval process is often lengthy and involves extensive qualification requirements. A personal credit score of at least 680 is usually needed.

Term Loan

A term loan is a common financing option, repaid over a set period with fixed terms. You can obtain these loans from traditional banks or online lenders, with loan amounts typically capped at $500,000. Approval depends on your business credit score, revenue, and personal creditworthiness.

Working Capital Loan

Working capital loans are designed to cover everyday operational expenses. This short-term financing option is especially useful for seasonal businesses that need a cash flow boost during slower months. Loan amounts vary depending on the type of financing and borrower risk, and higher interest rates may apply to loans with easier approval criteria.

Business Line of Credit

A business line of credit allows for flexible borrowing when you’re unsure of the exact amount needed. You can access funds up to a pre-approved limit, borrowing and repaying as necessary. Interest is only charged on the amount you use, making it an appealing option for ongoing projects. However, access to the credit line ends after the draw period, typically between 12 and 24 months.

Merchant Cash Advance (MCA)

An MCA provides a lump sum of cash in exchange for a percentage of future sales receipts. Repayment happens daily or weekly through automatic deductions from sales. Although MCAs offer fast funding and less stringent qualifications, they can be expensive, with high factor rates that increase the overall cost of borrowing.

Invoice Factoring

Businesses that bill clients through invoices can use invoice factoring to access funds quickly. A factoring company buys outstanding invoices, advancing a portion of the uncollected amounts. Once the company collects the invoices, they send the remaining balance to your business minus fees, which typically range from 0.5% to 5%.

Equipment Financing

Equipment financing helps businesses acquire necessary machinery or tools. Loan amounts are often based on the cost of the equipment, with lenders typically covering 80% to 100%. The equipment itself often serves as collateral, and loan terms range from three to 10 years.

Steps to Apply for a Business Loan

Applying for a business loan involves several key steps that ensure you are prepared for the financial commitment. First, gather necessary documentation, which may include financial statements, tax returns, business plans, and details of collateral, if required. The next step is to fill out the loan application, often accompanied by a personal and business credit check. Different lenders will have varying forms and processes, so be prepared for some differences depending on the type of loan.

Once the application is submitted, lenders typically take anywhere from a few days to a few weeks to process the application and assess the risk. The timeline for approval can vary, with SBA loans often taking longer due to more stringent requirements. After approval, funds are disbursed, and you will begin the repayment schedule according to the loan agreement.

Business Loan Requirements

Loan qualification criteria depend on the lender and loan type. However, some common requirements include:

• Minimum Credit Score: A business and personal credit check is often required. SBA loans typically demand a score of at least 680, while equipment financing and lines of credit may require 630 or higher.

• Annual Revenue: Lenders usually expect a minimum level of business revenue to ensure the ability to repay the loan.

• Time in Business: Businesses that have been operational for one to two years generally have a higher chance of approval. Some financing options may accept businesses with six months of operations.

• Debt Ratio: Lenders may examine your debt-to-income (DTI) ratio and debt-service coverage ratio (DSCR) to assess your ability to handle additional debt.

• Collateral: Secured loans require valuable assets as collateral, such as real estate or accounts receivable.

• Personal Guarantee: Some loans may require a personal guarantee, which makes you personally responsible if the business cannot repay the debt.

By understanding these requirements and potential loan options, you can increase your chances of securing the funding your business needs for continued growth and success.

Alternative Funding Options

For businesses that might not qualify for traditional loans, there are alternative funding sources worth considering. Crowdfunding, for example, allows you to raise small amounts of money from a large group of individuals, often through online platforms like Kickstarter or Indiegogo. This method can be particularly useful for startups and creative ventures.

Venture capital is another option, especially for high-growth startups. Venture capitalists invest in businesses in exchange for equity, meaning they take partial ownership of your company. While this can be a great way to raise funds without taking on debt, it also means giving up a portion of control over your business.

Finally, business grants offer funding without the need for repayment. However, grants are typically competitive and come with strict eligibility requirements. They are often industry-specific or tied to certain social goals, such as environmental sustainability or job creation in underserved communities.