How Do Small Business Loans Work?

How business loans workA Beginner’s Guide to Business Loans

Small business owners must be experts on many subjects, but most have no idea how financing and small business loans work. That’s not a surprise, because there is no simple answer, but it is a very important one when we consider that over 80% of businesses that fail do so because of cash flow issues. Knowing what type of small business loan to pursue, where and how to apply, and which details are most important are vital to receiving favorable loan terms and ensuring that the loan can be repaid in full.

Small Business Loans by Type

Depending on the type of business loan, they can have very different purposes and may work differently from each other. Generally speaking, all business loans are considered debt financing, and are used to obtain the cash needed to help a business grow. Lenders, bank or non-bank, offer loans in exchange for charging an interest rate as a percentage of the loan’s principal.

Loans are paid back over a pre-determined amount of time, known as a term, using regular payment intervals. While business loans all work with this basic concept, the term and payment structure can vary by type of loan. Lines of credit, for instance, allow the borrower to take funds and repay them several times over the course of the term. Equipment loans can come from a variety of sources and may be wildly different from other loans because they are tied so closely to the equipment they are issue for. In order to determine which loan is best for a business or business owner, we must first outline the types of loans and their purposes.

Term Loans

Term loans are what most people think of when considering needing financing. After application and approval, a business receives an agreed-upon sum of money that must be repaid, plus interest, over a set amount of time (term). In most cases, term loans involve larger amounts of money, which means that they are most likely the financing tool of choice for things like equipment and property purchases.

Term loans generally offer repayment periods that are longer than other financing methods, which may make them more accessible with lower monthly payments. Interest rates vary by lender but tend to be on the lower end of the spectrum of business financing methods.

Short Term Loans

With a basic concept that looks a lot like a regular term loan, short-term loans involve much smaller amounts of money and are paid off in less time. They also carry higher interest rates and usually stricter requirements on the term length.

Short-term loans, with their more condensed and expensive terms are not as easy to pay off as their longer-term counterparts. Sometimes requiring weekly or daily payments, they can be difficult for many small businesses to repay and grow to be very expensive over a relatively short amount of time. Even so, shorter terms mean less time for interest to accrue and less time paying overall.

Most short-term loans have terms up to 18 months but can be obtained with terms as short as 3 months. Interest rates will not usually reach anywhere near the affordability of traditional loans, sometimes reaching well into double digit percentages.

Equipment Loans

Many times, a business owner will want to finance a piece of equipment directly instead of using funds from a general-purpose business loan. Equipment loans are considered secured, because the item being purchased is used as collateral for the loan. Since the funds are issued to pay for a specific piece of equipment, the terms and conditions of the loan revolve around that item. Items that are high-depreciation or used in high-risk industries like construction may have different terms and interest rates than other types of equipment.

In many cases, the amount able to be borrowed can be the entire purchase price of the equipment, but down payments are required at times. The term is usually tied to the projected usable life of the equipment. Most lenders view equipment loans as lower-risk, since they have collateral for their funds, and price the loans accordingly.

Lines of Credit

Lines of credit function much like a credit card, in that a borrower is approved for a certain amount of money and can draw funds against the line until that limit is reached. Lines are generally more complex than traditional loans in their pricing, terms, and requirements. Lines of credit are a common and popular tool for business owners to pad their operating cash and handle short-term expenses.

Business lines of credit can reach very large sums of money, sometimes over $1 million, and have terms of up to 5 years. Unlike credit cards, many lines can have interest rates as low as 5% and don’t usually exceed 25%. Also, different than credit cards, lines of credit funds are issued as cash and do not require a fee for cash advances.

SBA Loans

Backed by the federal government and issued by several different types of lenders, Small Business Administration (SBA) loans are a popular option for businesses that meet the strict requirements of the program. The SBA insures the funds that lenders issue to business owners under several different loan programs, each designed to accommodate or promote different industry types, owners’ backgrounds, or geographic location.

This video from Biz2Credit about SBA Loans is a helpful lesson on the types of loans backed by the Small Business Administration.

The loans themselves are long-term loans that, once issued, function very similarly to normal loans. Since the funds are at least partially insured by the government, lenders are on the hook for much less risk, meaning they are generally more motivated to lend to borrowers of all types. Terms are usually better and interest rates more favorable as a result.

The tradeoff to these benefits are the sometimes-strict requirements to obtain a loan, ranging from the industry that a business functions in to the background of the owner themselves. These loans are some of the best deals on the market, with interest rates going as low as 6.5%.

Application Process

Most loans require minimum conditions be met before funds can be issued to a borrower. In the case of banks and credit unions, the government places strict credit and background requirements on the borrowers, which can limit the amount and types of loans that are able to be issued.

business loanSmall Business Loans: Applications

Short-term loans, long-term loans, and lines of credit require several pieces of information from potential borrowers, as well as an agreement to submit credit and tax information. In most cases, credit scores are required to be north of 600 and the business must be generating somewhere around $100,000 in annual revenue. With their higher interest rates and shorter terms, some short-term loans will allow lower credit scores and less annual revenues. Some of the information collected includes:

  • Driver’s license
  • Bank statements
  • Business tax returns
  • Personal tax returns
  • Personal Credit Score
  • Business Credit Score
  • Proof of business ownership
  • Balance sheet
  • Profit and loss statement

Equipment Financing

In some ways, the requirements to finance equipment are very similar, but there are added layers of information involved:

  • Driver’s license
  • Bank statements
  • Personal credit score
  • Business credit score
  • Business tax returns
  • Equipment pricing and other information

SBA Loans

In addition to traditional loan requirements, SBA loans typically require:

  • Information on loan purpose
  • Proof of citizenship
  • Business size disclosure
  • Personal resource disclosure
  • Proof of loan purpose

Types of Lenders

There are nearly as many different options for where to get a loan as there are for the type of loan being applied for. Ultimately, the type of lender will be determined by a few factors:

  • Borrower – Certain borrowers may need special accommodation to be able to receive loan funds. Bad credit, unstable income or revenue history, unknown or unproven immigration status, and several other factors impact an individual or business’ ability to borrow. Traditional lenders like banks and credit unions are held to strict standards by the government that may limit their ability to issue funds to applicants with nontraditional backgrounds
  • Loan types and specifics – Many lenders focus on a particular type of loan or specialize in financing specific industries – like agriculture or restaurants. In some cases, lenders will build their operations around specialty terms or credit requirements, making them able to issue loans at better prices than others
  • Loan size – Smaller lenders cannot lend to the extent that larger lenders can. It sounds simple, but its not cut and dried, and can vary wildly depending that lender’s business cycle, the time of year, and number of other loans that institution has recently issued. Typically, loans that are very large will require an application with a national bank or lender that specializes in high-value loan transactions

Equipment lenders may not be banks or lending institutions at all. Several manufacturers (OEMs) have their own in-house financing operations, designed specifically to issue funds to purchase their goods. These OEMs may offer incentives to buy certain types of equipment, such as a more expensive product or one that is from an outgoing model line. Borrowing from a manufacturer can be a great deal, and one that offers the best pricing for that equipment, but these types of loans usually lack the personal relationship that can come from knowing a loan officer or lender at another institution.

Non-bank lenders have become very popular in recent years. In many cases based on the internet only, these institutions are not typically bound by the strict regulation that banks and credit unions are, meaning they are able to set their own terms and borrower requirements. This can mean great pricing and very generous borrowing limits for applicants and may mean that the borrowers are able to shop for their loans without ever needing to speak directly to a person.

Since non-bank lenders can be more flexible with their terms, pricing, and loan limits, they are also more able to require higher interest rates and charge higher fees than traditional lenders. While this is not always the case, the onus is on the borrower to make sure they have investigated all the “fine print” and have determined that the loan’s conditions are favorable to their needs and situations.

Each situation is different and no one solution will fit as intended in every case. As more options become available, so does the amount of information, and potential borrowers can end up doing themselves a major disservice by failing to research the choices that they have in front of them. Knowing the types of loans and their purposes is just half the battle. Business owners must know themselves and their operations inside and out to know if a loan or other financial product is right for them.