Updated October 15, 2022

How Do Small Business Loans Work

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Funding can be essential for new business owners. How do small business loans work? Can you qualify? Are they expensive? Read on to learn more.

Starting a new business may seem daunting. And for those without capital, it can be impossible.

Even an established business could be in trouble if you lack the money to grow.

Without the right funding, you could miss out on growth opportunities. Or you could get overwhelmed by expenses.

However, with the right lender, there's potential.

What loan size do you need?

That's where small business loans come in. But how do they work?

Read on to learn how these loans can help your business and see if you qualify.

What is a Small Business Loan?

A small business loan is funding to help you achieve your business goals. You can get them from traditional banks, credit unions, government institutions, and online or alternative lenders.

These loans are typically used to grow a business, help with daily expenses, or pay for other debts. But some loans let you start a brand new business.

What is the purpose of your loan?

If you're starting a business, one approach to raising funding is to look for investors. This can work great, but you'll have to give up some ownership in your company in exchange for the funds.

With a small business loan, you can still gain funds without losing ownership of your company.

They are typically cheaper than credit cards. However, most are only available to those with a solid financial background.

Will you qualify? Let's cover that next.

Most small business loan providers require a minimum credit score of 600. If you need to improve your credit score, you can consider using some of the best credit repair software.

Are Small Business Loans Easy to Get?

Small business lenders consider many factors when reviewing your loan application.

Factor #1: Personal and Business Credit Scores
Most lenders will look at your personal credit scores since it tells them how well you manage your debts. A good personal credit score is considered 670 or above.

If you've been in business for a while, you may also have built business credit. It's best to have a business credit score of 80.

A poor credit score can limit your options. Worse, it may automatically lead to a denied application.

Pro tip: Some alternative lenders don't consider credit scores for small business loans. However, monitoring your credit will help you report any mistakes as soon as possible.

Factor #2: Your Financial Record
Your business should have a solid financial record of at least two years. You should also have funds available for a down payment (if necessary).

But you might not have much to show if you're a newer startup. This would mean the factors below are more important.

Factor #3: Your Cash Flow
You'll need sufficient cash flow to pay back the loan. For this, you can determine what you can afford and plan for its repayment. Sometimes, a down payment is required upfront. It can amount to up to 30% of your loan.

Factor #4: Your Business Plan
Finally, you must also have a convincing business plan. It can build the lender's confidence in your company and show that you have a purpose in mind for the loan. Stating exactly what you'll use the money for could increase your chances of getting approved.

Business Loan Approval Odds

Traditional banks and government institutions could take weeks or months to approve your application. However, online lenders might be able to process your application within minutes.

Keep in mind that a lack of requirements can lead to rejection or only partial approval. For example, according to Federal Reserve's Small Business Credit Survey (2019), 43% of businesses applied for financing.

9% of them received none, 14% received some, and 20% received all financing requested.

ReasonsPercentage of Businesses that Failed to Seek Financing
Low credit score36%
Insufficient collateral35%
Debt load35%
Insufficient credit history33%
Weak business performance23%
Other reasons5%

54% of businesses who applied for $250,000 or less were not approved for the full amount.

ReasonsPercentage of Businesses that Received Less than Requested Funding
Low credit scores/ high credit risk91%
Low profitability67%
Firms in the urban areas56%
Startup firms (time in business)63%

If you're prepared for all of this, i.e., you have a good business and personal credit score, strong finances with ample cash flow, and a well-thought-out business plan, it may be easier for you.

Before choosing any small business loan, it's better to seek professional advice first. Service Corps of Retired Executives (SCORE), for example, offers free mentoring service supported by the Small Business Administration. This service will connect you to retired business people in your industry.

The Basics of a Small Business Loan

Financial institutions will lend your small business money to help your company's needs. This money could serve as your working capital, payroll, payment for other loans, etc.

In return, they earn money through the interest and fees associated with the loan.

When approved for a small business loan, lenders may give the money through a lump sum or credit line, depending on the loan you applied for. Repayment methods will also vary.

Lenders may ask for collateral or a personal guarantee. Sometimes, both are needed, especially for an SBA loan. These back up your loan in case your business defaults.

A personal guarantee may help you gain access to more funding. However, you would be pledging your personal assets to cover the loan if you had to default.

Who Can Apply for a Small Business Loan?

Any small business can apply for a small business loan. If you're applying for an SBA loan, you'll need to meet their size standards to be considered a small business.

Typically, lenders require you to have been in business for at least two years. But small business loans are also available for those wishing to start a new business.

To apply, you'll need to meet the requirements of the lender. These requirements typically revolve around:

  • Credit scores
  • Annual revenue
  • Assets or a personal guarantee
  • Your business industry

Looking to get a startup business loan with no money? Microloans and business credit cards are easiest to get funding as a startup. If you don't have sufficient cash flow for a microloan, you can instead discuss your financial projections in your business plan. You can also opt for loans like equipment financing or invoice financing, where your asset is the collateral itself.

What Can You Do With a Small Business Loan?

Small business loans cater to different business needs. They typically have limitations on where you can use them.

For example, the SBA 504 Loan can be used for machinery and equipment but should not be used for inventory. The lender's website or contract will likely mention this.

Your business proposal should also mention where you intend to use the loan. Depending on the loan, you can use the funds for:

  • Cash flow for daily expenses
  • Debt consolidation or refinancing
  • Purchasing equipment
  • Purchasing inventory
  • Purchasing real estate
  • Remodeling your real estate
  • Marketing or advertising
  • Expanding the business
  • Franchising the business

Remember that you can't use small business loans to cover personal expenses such as home purchases or personal vehicles.

How Much of a Business Loan Can You Get?

According to the Federal Reserve, the average small business loan as of 2017 was $663,000. If we break it down among different lenders, the average loan amounts are the following:[1]

  • For large national banks: $564,000
  • For smaller banks: $184,000
  • For SBA loans: $107,000

Minimum and maximum loan amounts vary per lender, but we've compiled some of the best types of small business loans.

  • Short-term loans: You can get short-term loans from about $5,000 to $250,000. For example, On Deck and Kabbage both have the $250,000 limit.

  • Long-term loans: These loans typically range from $25,000 to $500,000. Funding Circle and Credibility Capital are two lenders you can check out in this range. If you're searching for a larger loan, Lendio can offer up to $2 million.

    What tenure do you prefer for your business loan?

  • SBA Loans: These are government-backed loans. Most SBA 7(a) Loans and 504 Loans have a maximum loan amount of $5 million. SBA microloans are capped at $50,000.

  • Business lines of credit: The range for this loan likely varies more than other loans. For example, On Deck offers a maximum of $100,000. Both Kabbage and Bluevine offer lines of credit up to $250,000.

  • Microloans: Lenders will also have varying ranges for this, especially since they are typically from nonprofit organizations. You can get as little as just $1,000 (like from Kiva). Typically, the maximum amount for a microloan is $50,000, but Accion can lend up to $100,000.

    Microloans are growing more and more popular. The microloan market is expected to reach $304 billion by 2026.

  • Equipment loans: The minimum amount for these loans is typically unlisted, but you can get up to $500,000. On Deck and Triton Capital offer up to $250,000, while Funding Circle can offer up to $500,000.

  • Invoice financing: Lenders will typically offer payment from 85% to 100% of your invoice. For example, Resolve can offer up to 90%, while FundThrough can offer up to 100% of your invoice.

  • Merchant cash advance: This will also vary greatly depending on your lender. Rapid Finance offers from $5,000 to $500,000. Libertas Funding can offer from $25,000 all the way up to $3 million.

Payments for small business loans vary based on the type of loan.

  • Payment through installment: You agree to regularly pay for a set period until you have repaid the total amount borrowed. This is typical for term loans, where you are lent a lump sum upfront. Repayment may either be done monthly, bi-monthly, weekly, or daily.

  • Payment through revolving credit: This payment is for business lines of credit and can be either made weekly or monthly. But it differs from other payments in that you only pay for the amount you borrowed, not the entire loan amount. Interest rates will also only be based on the amount you used.

  • Payment through cash flow: This could be through your debit and credit card sales (as in merchant cash advances) or invoices (as in invoice financing). When you repay depends on the type of loan. For example, you'll have to repay the lender daily for merchant cash advances.

Sometimes, borrowers can modify or suspend payments, which is called loan deferment. If you aren't able to repay your loan due to circumstances such as a pandemic, lenders may allow you to "pause" the payments. Typically, this can last one to three months. SBA disaster loan deferments, however, can last 12 to 24 months.

You can make payments directly through your bank accounts (through ACH) or through checks that may come with a check processing fee.

If you make your payments through ACH, you allow the lender to access your business account to make the necessary withdrawals directly.

Small Business Loans for New Businesses

You can opt for government-backed microloans when starting a business and online small business loans if you're already a startup.

Microloans from the SBA

The U.S. Small Business Administration guarantees the loans of some intermediary lenders. They are typically nonprofit, community-based organizations that offer microloans of up to $50,000.

These loans are specifically for small businesses and not-for-profit childcare centers.

SBA Microloans are ideal for those starting a business because lenders typically don't need a credit history and won't ask for a high income to get approved.

But because requirements will still vary per lender, some still require a minimum credit score.

How does it work?
On average, SBA microloans are around $13,000. SBA provides the funding while lenders process the application, distribute, and manage the loan. The maximum repayment term is six years.

If you choose this loan, keep in mind that you cannot use it for existing debts or purchasing real estate. However, you can use it for working capital and buying supplies and equipment.

Microlenders typically only serve specific states, so you'll need to look for one in your area to apply. SBA can help you through Lender Match.

Line of Credit from Online Lenders

As a startup, a business line of credit could be easier and faster to get than a traditional loan.

Some online lenders accept applications even with bad credit scores.

And a business line of credit is a flexible option. Instead of a lump sum loan, you get a revolving line of credit where you can draw upon repeatedly when needed.

Compared to traditional banks, you can get your application results from online lenders within minutes.

How does it work?
The maximum amount you can borrow depends on the lender. Bluevine, for example, can lend you up to $250,000, while Fundbox can offer up to $150,000.

If you get a revolving credit line, you only need to pay interest for the amount you borrowed, replenishing the loanable amount every time you make a payment.

Some online lenders offer unsecured small business loans, meaning you don't need business assets to qualify, which could be a big help for a small business.

Remember that some loans will have monthly fees while others won't.

Personal loans may be another option if you're just starting. You can use them for business if the lender doesn't prohibit them. They are typically unsecured, but most lenders only approve up to $100,000 instead of small business loans reaching $5 million.

Small Business Loans for Expanding Your Business

If you're already an established business, say, with five years or more of experience, then you may be looking to expand through small business loans.

A stellar financial background will give you more choices. You can choose from various small business loans from government-backed loans, banks, credit unions, or alternative lenders.

SBA Loans: 7(a) Loans and 504 Loans

The U.S. Small Business Administration Loans (SBA Loans) may be the most popular if you're looking for government-backed loans.

Aside from microloans, they also have guaranteed 7(a) Loans and 504 Loans.

The guarantee works similarly to collateral. If a business fails to repay a lender, the lender can recover the guaranteed amount from the SBA.

This lessens the risk to lenders while increasing accessibility for small businesses.

How does it work?
Each loan has limitations on what it can and cannot be used for.

SBA 7(a) Loans can be used for the following:[2]

  • Working capital
  • Payment for other business debts
  • Purchasing supplies, fixtures, or furniture

SBA 504 Loans can be used for:[3]

  • Purchasing or improving facilities
  • Purchasing equipment and machinery
  • Purchasing or improving the land, buildings, or utilities

However, you can't use them for inventory, working capital, payment of other business debts, or investing in rental real estate.

To qualify for a 504 Loan, you must be a for-profit company in the United States with a net worth of less than $15 million. For the last two years before your application, you also need an average net income of less than $5 million.[4]

Term Loans

Term loans are widely available from various lenders, from traditional institutions to alternative or online lenders.

You can choose from short, intermediate, or long-term loans.

Remember that longer terms will typically require stronger revenue and more years in the business. So short-term loans may be the most suitable for small businesses.

How does it work?
Simply put, lenders give you a lump sum of the amount you borrowed, to be repaid regularly with a fixed amount. Repayment is typically made monthly, but this depends on your lender.

There are term loans available for almost any business need.

Generally, you can use them for:

  • Working capital
  • Purchasing inventory or equipment
  • Purchasing or refinancing real estate
  • Expanding the business

You can get about $25,000 to $5 million in small business loans for a term loan. Down payment and interest rates vary from lender to lender.

National Funding is a great option because you only need to have been in business for at least six months and have a minimum credit score of 600. Their terms last from four months to two years, which you can repay daily or weekly.

As a small business, you can borrow $5,000 to $500,000, depending on your application.

Small Business Loans for Specific Purposes

There are also small business loans available for particular needs.

If you need to purchase a company vehicle, new real estate, upgrade equipment, or start a professional practice, there are specific loans for each.

Auto loans

An auto loan could be a good option if your business needs a truck, van, or car. You can also use it to refinance an already owned company car.

What makes it convenient is that the vehicle itself serves as collateral.

Heavier vehicles may be considered for equipment financing. Bank of America, for example, limits auto loans for vehicles less than 2.5 tons.

Although you can technically use other small business loans to purchase these vehicles, comparing auto loan rates against them could help you compute the best option.

How does it work?
These are term loans used for business vehicles only. The lender provides you a lump sum that you must repay for a specific period with interest.

When purchasing vehicles, a lower monthly payment isn't always better. Lower monthly payments lead to longer terms. Sometimes, you pay more with a longer term due to interest.

National Funding also has commercial vehicle financing of up to $150,000 and can help those with bad credit.

Commercial real estate loans

As the name suggests, these are loans used for purchasing or refinancing real estate.

Although typically a term loan, some lenders offer a commercial real estate line of credit. Wells Fargo, for example, can offer a credit line of $50,000 to $500,000 for this type of loan.

Real estate loans backed by the SBA are also available as 504 Loans.

How does it work?
To apply for a real estate loan, you will need good credit, an ideal debt-to-income ratio, and a down payment.

Once approved, you will have to use most of the loan for your business. For example, 51% should remain for your business if you plan to lease the property.

Equipment Loans

If your business uses equipment, you can expect the need to upgrade equipment or prepare for its maintenance.

Equipment loans are specifically there for that purpose. Most are term loans. The equipment you purchase is the collateral itself, so there's not much risk for lenders.

These loans are also available as a line of credit or lease to own.

How does it work?
Through equipment loans, you can get financing for 100% of the cost of the equipment. Repayment can sometimes be up to the life of the equipment.

But the con is that if your equipment breaks early, you'll still have to pay for the broken equipment per the agreed term.

Lenders will also typically ask for a down payment. Because these loans have lesser risks for lenders, you can expect lower interest rates.

Both traditional banks and online lenders finance equipment loans.

A good equipment financing option would be Triton Capital's Equipment Loans. The minimum credit score they recommend is 600 with a maximum loan amount of $250,000.

Medical Practice Loans

Whether you're a doctor, a veterinarian, or a different healthcare professional, small business loans are available to help fund your practice.

Bank of America, for example, has medical loan offers for each, including physicians and optometrists. Their offers can amount to up to $5 million.

These loans may be available as term loans or credit lines.

How does it work?
Medical practice loans are available from traditional banks and online lenders, which you can use as you see fit in your business.

Typically, you can use them to:

  • Start your practice
  • Purchase a property for your practice
  • Advertise or market your practice
  • Purchase or upgrade equipment
  • Use as payroll for your employees and partners
  • Purchase ambulatory vehicles
  • Fund community outreach programs
  • Fund mergers or acquisitions

Other professional practice loans are also available from banks. Home Street, for example, has a legal practice lending program for sole practitioners and firms. They can cover up to 80% of the financing for up to 7 years.

Should You Get a Small Business Loan?

Small business loans will undoubtedly help you reach your goals as a business. However, you need to be at the right state to take on a loan.

A loan can help make or break your business. It can give you the funds needed to grow your business or cover needs during slow seasons. Or it can bring huge debt to your business, and put both your business and personal assets at risk.

You want to be clear on your purpose for getting the loan. Some loans are more suitable than others. Some are ideal for the long term, while others are for short-term needs.

When is the Best Time to Get a Small Business Loan?

It might not seem like it, but the best time to apply for a small business loan is when you have good credit and ample cash flow.

When your company is in good standing, you'll be able to meet requirements easily. You'll also be able to "shop around" for lenders instead of taking on a more expensive loan that's easier to qualify for.

It's also essential that you, as an individual, are in a comfortable financial position if you decide to apply for loans needing a personal guarantee.

If you find that you and your business are already in an ideal position, your goals can determine when you'll need to upgrade equipment, hire new employees, or expand the business.

The application process can take a while, especially for traditional financial institutions. However, online lenders may approve you in minutes if you're in a rush for a loan.

The Bottom Line

In summary, small business loans are important extra funding for your business needs.

Lenders will have different terms or offers, depending on the type of loan. If you qualify and get approved, you'll be handed the amount in a lump sum or through lines of credit.

Repayment will vary, but typically, they could be made through installment, cash flow, or credit lines. You could perform this through direct transfer or check payments.

There are more types of small business loans not discussed in this article. But we've focused on those you can use as someone relatively new in the business.

Remember that the best time to apply for a loan would be when you're comfortable financially.

References

  1. ^ Federal Reserve Board. E.2 Survey of Terms of Business Lending MAY 1-5, 2017, Retrieved 9/7/22
  2. ^ U.S. Small Business Administration. How do I use the 7(a) loan?, Retrieved 9/7/22
  3. ^ U.S. Small Business Administration. How do I use a 504 loan?, Retrieved 9/7/22
  4. ^ U.S. Small Business Administration. Am I eligible?, Retrieved 9/7/22

Write to Karen Eloriaga at feedback@creditdonkey.com. Follow us on Twitter and Facebook for our latest posts.

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