Business loans are financing options provided by banks, credit unions, online lenders, and other financial institutions to small businesses and entrepreneurs. They allow companies to access capital to start or grow their operations. Business loans have become increasingly popular in recent years as more small businesses look for funding.
Loans are an essential source of financing for companies of all sizes. They provide an injection of capital that can be used for a variety of business purposes like purchasing inventory and equipment, expanding facilities, hiring employees, marketing efforts, and covering operating costs. Many small businesses rely on loans at some point, especially in the early stages when profitability and positive cash flow have not yet been established.
Business loans play a crucial role in the economy by enabling the creation of new companies and funding business growth and expansion. They allow entrepreneurs to turn their ideas into reality. Access to capital provides small businesses with the means to compete, innovate, boost productivity, and create jobs. The availability of financing contributes to a thriving small business sector and broader economic growth.
Types of Business Loans
There are several main types of loans that businesses commonly use to obtain financing. Each has its pros, cons, and requirements.
SBA Loans
Small Business Administration (SBA) loans are a popular financing choice for small businesses. The SBA partners with lenders to provide low-interest loans that may be easier to qualify for compared to conventional bank loans.
Pros:
- Low interest rates
- Long repayment terms of up to 25 years
- No ballooning payments
- Funds can be used for a wide range of business purposes
Cons:
- Lengthy application process with lots of paperwork
- Restrictions on how funds can be used
- SBA takes a cut of the total loan amount
The most common SBA loans are 7(a) loans up to $5 million and 504 loans up to $5.5 million for commercial real estate and other fixed assets.
Bank Loans
Getting a loan directly from a bank or credit union is another way small businesses can get financing. Traditional term loans and lines of credit are available.
Pros:
- An established relationship with the bank may help
- Approval timeline faster than SBA loans
- Loan uses less restricted
Cons:
- Higher interest rates usually
- Shorter repayment terms
- Strict credit score and revenue requirements
Banks offer various loan products like commercial real estate loans, equipment loans, and revolving lines of credit. Loan amounts and terms depend on the specific bank and borrower.
Alternative Loans
Alternative online lenders provide other options for financing not offered by traditional banks. This includes merchant cash advances, factoring, and startup business loans.
Pros:
- Quick access to capital
- Less strict qualification requirements
- Funding within days in some cases
Cons:
- Very high interest rates
- Large repayments if the business has slow revenue periods
- Questionable business practices by some lenders
Alternative loans work for some businesses, but the high costs make them risky if used improperly.
Uses for Business Loans
Business loans can be used for a variety of purposes to help start or grow a business. Some of the most common uses include:
Working Capital – One of the most popular uses for small business loans is to increase working capital. This provides funding to cover day-to-day operating expenses like payroll, rent, supplies, etc. It helps businesses smooth out cash flow issues. The pros are it provides short-term liquidity. The cons are it doesn’t provide long-term stability.
Equipment – Loans can be used to purchase equipment like machinery, vehicles, hardware, and tools. This allows businesses to acquire the necessary equipment without large upfront costs. The pros are it allows you to acquire the necessary equipment. The cons are equipment loses value over time.
Real Estate – Business loans can be used to purchase commercial real estate like office buildings, retail space, warehouses, etc. It allows businesses to acquire the facilities they need. The pros are you acquire a hard asset that generally appreciates over time. The cons are real estate loans usually require a down payment and have larger monthly payments.
Loans
Marketing – Loans can provide funding for marketing initiatives like advertising, website development, branding, etc. This helps businesses promote themselves. The pros are it allows investment in business growth. The cons are marketing costs provide no guarantees.
Inventory – Businesses can use loans to buy inventory in bulk for discount pricing or to meet increased demand. This helps maintain stock levels. The pros are inventory is liquid and can spur sales. The cons are unsold inventory can be a risk.
Overall business loans provide financing to acquire the assets and capabilities needed for business growth or success. But they also come with repayment obligations, so the benefits of the loan should outweigh the costs. Careful planning is required to ensure the loan is used effectively.
Loan Requirements
To qualify for a business loan, lenders will evaluate your business and personal finances. The main criteria they consider are:
Credit score – Most lenders require a minimum credit score of 680-720 to qualify for a small business loan. The higher your score, the better your chances. A low credit score signals a higher risk to the lender.
Time in business – Lenders usually want to see that your business has been operating for at least 2 years to demonstrate stability and profitability over time. However, startups can sometimes qualify for loans designed for new businesses.
Revenue – Your annual revenue gives lenders an idea of your ability to repay the loan. Many lenders look for at least $100,000 in annual revenue.
Collateral – For larger loans, lenders may require you to put up collateral like real estate, equipment, investments, or business assets to secure the loan in case of default.
Personal guarantee – For small business owners, most banks will require you to personally guarantee the loan, making you personally responsible for repayment if the business can’t pay.
The exact qualifications depend on the lender, loan amount, and your industry. Be prepared to provide financial statements, tax returns, business plans, and other documents to substantiate your eligibility when applying. A long, healthy credit and business history goes a long way toward improving your chances of loan approval.
Loan Application Process
The loan application process involves gathering documents, completing application forms, going through underwriting, and receiving a loan decision. Here are the key steps:
Documents Needed
You’ll need to have the following documents ready to include with your loan application:
- Several years of business and personal tax returns
- Business financial statements and records
- Business ownership documents like articles of incorporation
- Personal financial statements and records
- Collateral documentation if applicable
- Business plan and projections
Having organized financial records will help ensure your application is processed smoothly.
Completing the Application
The loan application will require you to provide details on your business operations, ownership structure, financial history, collateral, and the amount and purpose of the loan. Be prepared to disclose in-depth information.
Applications can often be completed online but may need to be completed in person at a bank branch. Provide clear, accurate, and complete responses on the application.
Underwriting and Review
After applying, the lender will begin the underwriting process. This involves analyzing your business’s finances, viability, risks, and ability to repay.
Underwriters will verify the information provided, review documents and records, and evaluate collateral. Your credit scores and reports will also be checked.
This comprehensive review determines if the lender will approve or deny the loan. Be responsive if the lender requests any additional documentation.
Receiving the Loan Decision
The lender will inform you once they’ve made a decision on your application. If approved, you’ll receive loan terms like rates, fees, repayment schedule, etc.
If denied, ask for an explanation. You may be able to re-apply after improving certain aspects of your business finances and operations.
With persistence and well-prepared documentation, securing small business financing is very achievable. Stay organized and transparent throughout the loan application process.
Loan Terms
When you take out a business loan, you agree to specific terms that dictate how you will repay the loan. Here are some key factors to be aware of:
- **Interest rates** – The interest rate determines how much you will pay in interest on top of the principal loan amount. Interest rates on business loans can be fixed or variable. Fixed rates stay the same over the life of the loan. Variable rates fluctuate based on market conditions.
- **Repayment terms** – This specifies how you will repay the loan – including the length of the loan (1 year, 5 years, etc), the payment amounts, and the payment frequency (monthly, quarterly, etc). Longer term loans have lower monthly payments but higher interest costs over time.
- **Prepayment policy** – The prepayment policy determines if you can pay off the loan early, and if so, if there are any penalties for doing so. Make sure you understand any prepayment penalties before committing to a loan.
- **Late fees** – If you miss a payment or pay late, high late fees can be assessed. Be sure your business has enough cash flow to make payments on time to avoid these. Some lenders offer a short grace period before applying late fees.
- **Collateral requirements** – Collateral is an asset that secures the loan. If you default, the lender can seize the collateral. Common collateral for business loans includes equipment, accounts receivable, real estate, or a portion of the business itself.
Understanding the loan terms upfront can prevent surprises later. Carefully review the loan agreement and ask the lender to explain all terms before signing. Negotiate for better terms if needed. Agreeing to the wrong loan terms can severely impact your business’s financial health.
Improving Your Chances
When applying for a business loan, it’s important to make your business look as appealing as possible to lenders. Here are some tips for improving your chances of getting approved:
Boost Your Business Credit Score
Lenders will check your business credit reports and scores, so maintaining excellent business credit is key. Check your reports for errors, pay bills on time, use business credit cards responsibly, and build up a long history of good credit. A higher score makes approval more likely.
Offer Collateral
Providing business assets like property, equipment, accounts receivable, or inventory as collateral significantly improves your chances. The collateral gives the lender more security that you’ll repay the loan. Having substantial personal assets to also offer as a guaranty helps too.
Show Strong Revenue and Profits
Lenders want to see you have a viable, profitable business capable of repaying debt. Provide financial statements showing steady revenue growth, net income, strong profit margins and cash flow. Highlight your major customers, contracts, and other revenue sources.
Prepare a Convincing Presentation
In your pitch and loan proposal, explain exactly why you need the financing and how you’ll use it to expand your profitable business. Present realistic financial projections showing how the capital will grow your company. Demonstrate you have an experienced team and a solid business plan in place. With a compelling presentation, you can win over lenders.
By taking these steps to improve your credit, assets, financials, and overall loan package, you can get on the path to securing the financing your business needs to take it to the next level.
Alternatives to Loans
Many small business owners seek out loans when they need funding, but loans aren’t the only financing option. Here are some alternatives to consider:
Crowdfunding
Crowdfunding platforms like Kickstarter and Indiegogo allow entrepreneurs to raise money from a large pool of individuals. This approach taps into the “crowd” to obtain small investments from many people.
The key benefit is you don’t give up equity or pay interest like you would with a traditional loan. The money raised is essentially free money that doesn’t require repayment (unless you offer rewards). The downside is there’s no guarantee you’ll meet your fundraising goal.
Grants
Government and nonprofit grants are another financing option to look into. For example, the Small Business Innovation Research program provides grants to small businesses working on innovative research and development.
Grants don’t need to be repaid like loans. However, grant funding is very competitive and typically requires lengthy applications with strict requirements.
Investors
You may be able to obtain startup capital from angel investors or venture capitalists in exchange for equity in your business. This avoids taking on debt but involves giving up ownership shares.
Venture capitalists and angels invest in companies they believe have long-term high-growth potential. You’ll need an appealing and viable business plan to attract their interest.
Bootstrapping
Bootstrapping means relying on your own funds and operating revenue to finance growth. This lets you maintain full ownership and control of your business.
The constraint with bootstrapping is that it limits how fast you can grow. With limited funds, you’ll need to start small and reinvest profits wisely. Bootstrapping works best for businesses with minimal startup costs.
The bottom line is that loans aren’t your only option for funding a business. Evaluate if alternative financing solutions like crowdfunding, grants, investors, or bootstrapping could be a better strategic fit.
Managing the Loan
Once you’ve secured financing, you’ll need to manage the loan properly to avoid potential issues. Here are some tips:
- **Keep detailed records** of how you use the loan proceeds. Lenders may require documentation showing the funds were used for approved business purposes. Keep receipts, invoices, bank statements, and other records. Track expenses against your original loan application and business plan.
- **Make loan payments on time.** Set up automatic withdrawals if possible to avoid missed payments. Even a single late payment can incur fees and penalties. Missed payments will damage your business credit and relationships with lenders.
- **Understand the tax implications.** Interest paid on business loans is usually tax deductible. Consult your accountant to deduct interest expenses appropriately. Any loan forgiveness may count as taxable income, so factor this into your planning if applying for relief programs.
- **Maintain business insurance.** Keep general liability, property, and other relevant policies up-to-date. Insurance can help protect your business if you’re unable to repay the loan for any reason.
- **Communicate with the lender.** Keep your lender informed about your business, especially any difficulties making payments. They may offer assistance programs or loan modifications if you reach out early about problems.
Proper loan management requires organization, planning, and open communication with lenders. By following best practices, you can ensure the loan provides ongoing value for your business.
Conclusion
Taking out a business loan is a big decision that requires careful thought and planning. With the right preparation and understanding of the process, you can obtain financing to start or grow your business.
To recap, the main types of small business loans include SBA loans, traditional bank loans, microloans, equipment financing, lines of credit, and alternative lenders. Consider what you need the loan for, as this will determine the best loan type and lender.
The loan application process involves gathering documents, filling out forms, and providing financial statements. Lenders want to see that you are creditworthy and have a viable business idea. Take steps to strengthen your application like improving your credit score, detailing your business plan, and providing collateral.
Be sure to understand the loan terms like interest rates, length, and repayment schedule. Compare options to get the best rate and avoid prepayment penalties. Read all agreements carefully before signing.
Once approved, use the loan funds only for approved business purposes. Make payments on time and in full to build business credit. Consider hiring an accountant to help manage the finances.
With careful planning, hard work, and strategic use of capital, a small business loan can be a valuable tool for starting and expanding a successful company.