How Do Business Loans Work?

Small businesses make up almost half of the private workforce in the United States—creating two out of every three new jobs. If you’re a small business owner, securing a business loan can help you start or grow your business, purchase necessary equipment or finance working capital needs. Understanding how business loans work can help you find the right loan for your business, which can be a lifeline when used responsibly.

What Is a Business Loan?

A small business loan is a type of commercial financing qualified businesses can get from traditional banks, online lenders and credit unions. Businesses can use funds to cover the costs that come with operating and growing a business, including everything from working capital and equipment purchases to larger purchases like real estate.

How Do Business Loans Work?

Business loans provide business owners with financing either as a lump-sum payment or credit line. In exchange for this funding, your business agrees to repay the money it borrows over time, plus interest and fees. Depending on the type of business loan, your lender may require daily, weekly or monthly payments until fully repaid.

Additionally, business loans are either secured or unsecured. Secured loans require collateral— something of value the lender can repossess if you fail to repay—to back the loan, like real estate, equipment, cash or investments. Unsecured loans, however, do not require collateral. Instead, you typically have to sign a personal guarantee agreeing to accept personal liability if the business doesn’t repay its debt as promised.

What Are Business Loans Used For?

You can use business loans for many different purposes. When you apply for financing, however, you will usually need to let the lender know how you intend to use the funds. Common uses include:

  • Startup costs
  • Commercial real estate purchases and/or remodeling
  • Cashflow for everyday expenses
  • Debt consolidation or refinancing
  • Equipment purchases
  • Inventory purchases
  • Business acquisitions
  • Business expansion
  • Business franchising
  • Marketing and advertising
  • Refinancing

You may notice a key type of purchase missing from the list above—personal expenses. In general, lenders will not allow you to use business loans to cover personal costs like residential home purchases, personal vehicles or other transactions that aren’t related to a business need.

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Common Types of Business Loans

Below you’ll find seven types of business loans you might want to consider if you need funding for your company. Using a business loan broker can be a handy way to find the best option.

SBA Loan

An SBA loan is a type of financing that’s backed by the U.S. Small Business Administration (SBA), which guarantees a portion of the money businesses borrow through these loan programs. Therefore, the risk is lower for the lender, and the lender may be willing to extend money to businesses that it might not otherwise approve for financing.

The interest rates on SBA loans can be competitive for well-qualified borrowers. What’s more, SBA loans typically range from $30,000 to $5 million and come with extended repayment terms—up to 25 years.

However, SBA loans also feature notoriously tedious qualification requirements. You should be prepared to jump through a lot of hoops and wait up to a few months to find out if you qualify. Having a personal credit score of at least 680 is recommended for these types of loans.

Term Loan

Business term loans are another common type of business financing that’s repaid over a set period of time. You may be able to get a business term loan from a traditional bank or an online lender. Newer businesses typically have a better chance of approval through online lenders because they typically offer more flexible qualification requirements.

These loans typically have terms ranging up to 10 years, offer loan amounts up to around $500,000 and annual percentage rates (APRs) that start around 9%. Your business’ history, annual revenue and creditworthiness, including your personal credit, typically determine which loan terms you’ll have access to.

Working Capital Loan

A working capital loan is short-term financing—typically a term loan, line of credit or invoice factoring—that can help businesses that need a cash infusion to cover day-to-day operating expenses such as payroll. Seasonal businesses, in particular, might benefit from a working capital loan during slow seasons when managing cash flow is a challenge.

Working capital loan terms will vary depending on the specific type of financing you apply for and the risk you pose as a borrower. In general, though, working capital loans can range from $2,000 to $5 million. As a rule of thumb, loans that feature easier-to-satisfy qualification criteria tend to come with higher interest rates and fees to offset the lender’s risk.

Business Line of Credit

A business line of credit offers a flexible way to borrow money when you don’t know the exact amount of funding you need upfront. This is because borrowers can access a credit line between $2,000 and $250,000 on an as-needed basis, similar to a credit card. What’s more, you can reuse your credit limit as you repay it throughout the draw period, and you’ll only owe interest on the amount you borrow—not the entire approved limit.

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Unlike business credit cards, a business line of credit’s draw period eventually expires, typically within 12 to 24 months. Once the draw period ends, the repayment period begins, and you’ll have to repay any unpaid balances, plus interest. The repayment period can range anywhere from six months to five years. During this time, you’ll no longer have access to your credit limit for borrowing purposes.

Merchant Cash Advance

A merchant cash advance (MCA) can be an easy way to access short-term financing when your business needs money fast. Business owners give the lender—often a merchant services company—a portion of future sales receipts in return for a lump sum of cash. This amount plus fees are repaid from the business’ individual sales or through automatic clearing house (ACH) payments on a daily or weekly basis.

However, the streamlined loan process and less stringent qualification criteria can be expensive. MCAs typically charge a factor rate between 1.2 and 1.5. For example, if the MCA amount is $10,000 with a factor rate of 1.2, the total payback amount will be $12,000.

MCAs may be a good option for businesses that experience a high volume of sales and need to access cash quickly—without qualifying for a traditional business loan.

Invoice Factoring

Businesses that use an invoicing system to bill other businesses may be eligible for invoice factoring. With this type of business financing, your business sells its outstanding invoices to a factoring company. The factoring company then advances you a portion of the uncollected invoices (often 70% to 95%) and becomes responsible for collecting the outstanding invoices. After collection, the factoring company pays your business the remaining balance minus the factoring fees. Factor fees typically range from 0.50% to 5% for each month an invoice remains unpaid.

Invoice factoring is a handy financing method for startups and new businesses that don’t have a strong credit profile yet.

Equipment Financing

Equipment financing can help your business finance necessary equipment, including small items like electronics and large manufacturing machinery. Loan amounts depend on the cost of the equipment being financed. While lenders typically finance between 80% and 100% of the equipment costs, it’s typical for them to also require a down payment of about 15%. Terms range between three and 10 years.

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Business Loan Requirements

Business loan requirements can differ depending on your specific lender and how you plan to use the funds. The type of loan you’re seeking also impacts the qualification criteria a lender may require before it will approve a new application for funding. In general, you can typically expect the following requirements:

  • Minimum credit score. A lender typically checks both your business and personal credit scores. The type of loan determines the minimum score required. For example, you should have a score of at least 680 to qualify for an SBA loan or a traditional bank loan, and 630 for equipment financing or business lines of credit. We also recommend good business credit.
  • Annual revenue. Some lenders may want to see a minimum amount of annual business revenue before you’ll be eligible for financing. This helps show your business can support future debt payments.
  • Time in business. Businesses that have been in operation for longer have a greater chance of loan approval. In general, lenders typically require a business to be in operation for at least one to two years. For some types of financing, businesses that have been in operation for at least six months are eligible.
  • Debt ratio. Lenders may also review your debt-to-income (DTI) and debt-service coverage ratio (DSCR). Your DTI weighs your monthly personal debt against your gross income while your DSCR measures your business’ annual net operating income in relation to its total annual debt.
  • Collateral. With secured loans, lenders require you to pledge collateral—something of value, such as accounts receivable or real estate—that they can seize if you fail to repay the loan.
  • Personal guarantee. Some lenders and loan types require a personal guarantee, which protects the lender in the case of a default. If your business doesn’t honor its loan agreement, the lender will require you to repay the debt with your personal funds.

On top of examining business loan requirements, you may also want to look over common problems that could prevent you from getting a small business loan. Sometimes knowing what not to do before a business loan application can be as helpful as understanding the steps you need to take to apply.

Frequently Asked Questions (FAQs)