September 23, 2019

Business Loans

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A small business loan can expand operations and grow your profits. But how do you pick the right loan for your business? Here's everything you need to know.

Before finding the right loan for your small business, you'll need to assess your needs.

Some common reasons for applying for a small business loan include:

  • Expanding your small business
  • Starting your small business
  • Cushion your cash flow
  • Finance equipment
  • Purchase inventory
  • Managing daily expenses

Keep reading to learn about your small business loan options.

Types Of Small Business Loans

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Choosing the ideal business loan can be overwhelming. But your business history, needs, and financial strength will help narrow down the field.

Read on to find out which small business loan is best for you.

When applying for a small business loan, consider the lender's perspective. Given the information you are supplying, would you lend the money to yourself?

Term Loans

Term loans are the most common form of business financing. Lenders give you the amount of cash upfront (typically $25k–$500k). You then pay it back over a set period of time with a fixed interest rate.

It takes one to five years to pay back a term loan with interest rates anywhere from 7% to 30%.

How to Qualify
You'll need a good credit score, a business history, and revenue. This option is best for strong businesses looking to expand.

Pros

  • The money is upfront
  • Consistent payment structure
  • The loan can be used for a variety of purposes
  • This loan is usually faster than other options

Cons

  • You need to be in business for a while
  • You need a credit score
  • Collateral or a guarantee may be required

When you apply for a term loan, be sure to ask about any fees, including prepayment penalties. Discuss the specific terms with your lender.

Small Business Administration (SBA) Loans

Small Business Administration (SBA) loans are among the most desirable because the SBA guarantees the loans.

The money from an SBA loan ($500–$5.5M) can be used for most common business purposes, including long-term fixed assets and operating capital.

These loans can help strong borrowers looking to grow or refinance existing debt. Business owners should be prepared to wait a while for approval.

How to Qualify
Business must be registered and operate legally, located in the U.S. or its territories, and cannot get funds from other financial lenders. The owner must have time and money invested into the business.

Pros

  • Lower down payments
  • Flexible overheard requirements
  • No collateral for some loans
  • Some loans require continued counseling
  • Competitive rates

Cons

  • More paperwork
  • Business owners still need good credit
  • Rates may be high compared to other options.

Long-term loans and low-rate loans, such as SBA loans or business lines of credit, require a higher credit score—around 700 and above. To learn more about SBA loans, click here.

Business Lines of Credit

A business line of credit provides access to funds to increase your credit limit. You only pay interest on the money you've used.

Business lines of credit work best as a short-term option. These lines of credit can help businesses manage cash flow or handle unexpected sudden expenses.

How to Qualify
Qualifications vary depending on the lender, though you will benefit from a strong credit rating and a solid business plan.

Pros

  • Balances cash flow during slow periods of time
  • No collateral typically required
  • Pay for exactly what you use

Cons

  • Some additional fees, like maintenance or draw fees
  • Strong credit needed
  • Solid revenue stream required
  • Difficult to apply for a business line of credit

Equipment Loans

These loans help you buy equipment for your business, and the equipment is your collateral.

The life of the loan matches the life of what you buy, and the rates depend on the value of your equipment and your business' strength.

How to Qualify
Qualifications depend on the lender, though you can expect your credit score, cash flow, and business plan to be considered. In some cases, you will also need to offer collateral.

Pros

  • You own the equipment and build equity
  • Good rates for strong credit

Cons

  • Down payments
  • Equipment may become outdated before the loan is up

Invoice Factoring

Customer invoices are normally paid in 60 days. However, you can get the cash now by selling invoices to a factoring company. The factoring company will collect from your business when the time comes.

This option works best for businesses that are looking for fast cash and are willing to give up control of their invoice process.

How to Qualify
In addition to good credit, you may also need a specific profit margin percentage or invoices that have not already been pledged as collateral to other organizations, such as a bank.

Pros

  • An option for fast cash
  • Easier approval than other traditional options

Cons

  • Invoice factoring can be costly
  • Loss of control over invoice collecting

Invoice Financing

Invoice financing is similar to invoice factoring. Instead of selling your invoices to another company, you use the invoices as collateral for a cash advance.

This option works best for businesses looking to maintain control over their finances.

How to Qualify
Qualifications are similar to those of invoice factoring. In general, you'll want to have good credit, no liens or encumbrances, and good invoicing practices.

Pros

  • An option for fast cash
  • Customers unaware their invoices are used as collateral

Cons

  • Invoice financing can be costly
  • You need to collect the invoice payment

Merchant Cash Advances

Merchant cash advances give you a lump sum of cash up front, though the repayment process can be tricky.

You can either withhold a percentage of your daily credit card and debit card sales or enact weekly withdrawals from your bank account

This option works for businesses that cannot get financing elsewhere, though you'll need to be able to make frequent repayments.

How to Qualify
Many lenders require at least 6 months in business, as well as a minimum 500 credit score and various specifications for your deposits.

Pros

  • Fast cash
  • Unsecured financing
  • The amount you owe does not increase
  • Can qualify even with bad credit

Cons

  • Possible high borrowing costs
  • Frequent repay can be difficult to track with cash flow
  • Lenders do not operate in a regulated industry

If your credit score is lower than expected, you may have a better chance getting an MCA or smaller business lines of credit.

Personal Loans

Using a personal loan for business purposes can be risky, but some small businesses with few options opt for this choice.

Newer businesses with strong credit are able to take advantage of personal loans. Banks may not lend to new businesses with little to no operating history.

How to Qualify
You'll need a strong credit score to qualify, though these loans may pose a risk to your score.

Pros

  • Startups and new businesses can qualify
  • Fast funding option

Cons

  • Cost of borrowing can be high
  • Not repaying the loan damages your credit score
  • Maximums of usually $50,000

Business Credit Cards

A business credit card is a revolving line of credit and can be a flexible way to finance business expenses. Be sure that you can pay off the card's monthly payments and not exceed the credit limits.

This option works for businesses that have ongoing business expenses spread out over a period of time, such as travel, utilities, and more.

How to Qualify
In addition to basic business information, such as annual revenue and estimated monthly spend, you'll need to calculate your total annual income and debt-to-income ratio.

Pros

  • Rewards and points on purchases
  • No need to put up collateral
  • Can be easy to apply

Cons

  • Can negatively impact your credit score
  • Variable interest rates
  • Added fees, such as annual fees

Microloans

Nonprofit organizations and alternative lenders offer microloans of up to $50,000, though most microloans offer significantly less.

Microloans are meant for startups, newer businesses, and businesses in lower-income communities.

How to Qualify
Most organizations require proof that you can repay the loan. You will need to be clear about how much money you need and why.

Pros

  • Low cost for small businesses
  • Distributed quickly
  • May come with added services, like training
  • Can be used to finance a variety of costs

Cons

  • Smaller amounts of money
  • Tough eligibility requirements
  • Additional fees from some lenders
  • Each lender has their own eligibility requirements

Lending Trends
While financing for small businesses has increased slowly since the 2008 recession, the amount is still less than the percentage of loans going to small businesses pre-recession.

Before You Apply

Finding the right loan is an important step forward for your small business. Consider these questions before you proceed:

  • Can I realistically repay this loan?

  • Will the payment fit into my cashflow, whether it is daily or monthly?

  • Am I 100% sure this is the lowest rate I can find?

  • Do I know and understand all fees associated with this loan?

If the answer to any of these questions is "yes," here are some factors that will impact your chances of getting a small business loan.

Credit Score
Small businesses owners with lower credit scores risk getting turned down for loans. If your credit score is below 680, review your credit reports from each of the three bureaus to find out why.

Your credit score is determined by your payment history (35%), debt owed (30%), length of credit history (15%), new credit (10%), and diversity of credit (10%).

For a more in-depth breakdown of your credit score, click here.

Business Plan
Potential lenders want to see a business plan plus a roadmap for how you'll return their money. Be sure to create and thoroughly review these documents beforehand.

Revenue
Lenders will review amount of money your business makes to determine your loan eligibility and how much you can pay back each month.

Your Debt Service Coverage Ratio (DSCR) tells lenders how much cash you have to pay off your debt.

To calculate your Debt Service Coverage Ratio:
Divide your cash flow by your loan payment amount. If you have $4,000 of cash flow every month, and your projected monthly loan payment is $1,000, your DSCR ratio is 4.

You'll want a DSCR of at least 1, though most lenders would prefer at least 1.5.

Amount of Funding
Before you apply, be completely clear on how much funding you need and whether or not this loan will help grow your business. Lenders will want to see a return on the investment.

Time in Business
Most lenders prefer a business with at least a two-year history, though online lenders may be a good option for businesses six months to one year old.

Common Paperwork for Small Business Loan Operations

Each lender will ask you for different paperwork. It's best to prepare all the documents ahead of applying.

Remember this rule of thumb: the longer the term of the loan, the more paperwork will be required.

Business Bank Statements
Lenders ask for bank statements running back three to 12 months.

Balance Sheet
Balance sheets, or statements of your financial position, give lenders a look at the company's recent financial history. Most lenders ask for a recent balance sheet updated in the past 60 days.

Profit and Loss Statements
These help lenders determine your business' cash flow and whether you can actually pay back the loan. Most lenders ask for documents from the past two years.

Business Debt Schedule
Lenders want to know if your business currently has debt and if so, how you pay it off and whether you can handle any additional debt.

Tax Returns
Your personal tax return verifies your income to employers. Be sure to file your most recent taxes before you apply or have extension paperwork ready.

Business Tax Return
If you can, prepare business tax returns from the past two fiscal years. If your business is an LLC or sole proprietor, and you do not file a separate return, be prepared to show any returns tied to your business.

Use of Loan
Most lenders ask for justification on how you will use the loan and how it will grow your business.

Business Plan
Lenders may want to see your business plan when applying for financing, which details the blueprint of your business. This gives lenders an idea of your business blueprint and direction.

Different lenders request different paperwork associated with your business, so be prepared to come with anything they might need.

Check the Details of Your Loan

Before you proceed with your small business loan, make sure you fully understand all the "fine print." This may include the loan cost, repayment structure, and term.

Here's what you need to know:

APR
The annual percentage rate, or APR, is the cost of a loan factoring in the interest rate and other fees. By comparing APR, you can ensure you're taking into account all fees across the board.

Loan Fees
You might think you're getting a great deal on a loan, but always check for hidden fees which may make the loan less attractive.

These can include:

  • Origination Fee
    This fee is the cost the lender incurs to make the loan. It covers things like administrative fees. In most cases, origination fees are given as a percentage of the principal loan.

  • Application Fee
    When applying for a loan, companies run a background check and acquire your credit report. Sometimes, lenders pass on this fee to you in the form of an application fee.

  • Guarantee Fee
    The SBA doesn't directly make the loan, but it does guarantee part of the loan for the lender. In order to do this, they have to pay a portion of the loan upfront. Sometimes this fee is passed onto the applicant.

  • Late Payment Fee
    Some lenders charge an added fee if you're late making a payment. To avoid this, consider setting up automatic payments from your account.

  • Prepayment Fee
    Paying off your loan early can cost you a fee. The fee is calculated as a percentage of the outstanding principal at the time you decide to pay it off.

  • Check Processing Fee
    Sending in payments via check may cost you a processing fee. Discuss this with your lender to ensure you won't be billed for your chosen payment method.

Be Wary of Predatory Lenders
Watch out for these warning signs when shopping for loans:
  • Interest rates significantly higher than market value
  • Fees greater than 5% of the loan value
  • No APR disclosed
  • No repayment schedule disclosed
  • Lender pressuring you to take the loan
  • Lender asking you to lie on paperwork or leave boxes blank

If you are unsure about the lender you're dealing with, double-check with a financial professional.

Denied for a Small Business Loan?

Not everyone is approved for a small business loan. Large banks have slowly been reducing the amount of small business loans over the past few years.

Sometimes, banks offer a specific reason for your rejection. If they don't offer an explanation, here are a few reasons your application may have been denied:

Bad Credit
Your credit score is one of the first elements lenders consider. A bad credit score indicates you have mismanaged your finances.

Weak Cash Flow
Collateral is important to lenders. Many small businesses struggle to keep enough cash in their accounts to make steady payments. Consider making a budget for each month to ensure your bank account has cash.

Not Enough Time in Business
Most lenders want to see a business history of at least 2–3 years to ensure that you're not using funds to get your business off the ground. Longer-standing businesses are also able to provide documents that lenders need, like proof of revenue and tax information.

Not Enough Preparation
Many small business owners underestimate the amount of documents and preparation that they need for a business loan application. If you weren't able to provide all the information your lender needed, you may be denied.

Lenders do not weigh every factor equally. Their biggest concern is that you're able to pay back the money you owe.

THE BOTTOM LINE

A small business loan can help your business grow and thrive. But finding the right loan can have a huge impact on your company.

Improve your chances of getting approved by being prepared. And remember to pay off the loan as soon as possible to reap the benefits for your business.

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