How Do Small Business Loans Work?

Small business loans are designed to help entrepreneurs start, expand, or operate their businesses. These loans can cover various expenses such as buying inventory, hiring employees, purchasing equipment, or acquiring real estate. You can obtain small business loans from banks, credit unions, online lenders, or community nonprofit organizations. The loan terms and interest rates vary depending on the lender, loan type, amount, and the borrower’s credit scores.

Typically, lenders prefer making loans to established businesses with a track record of profitability. However, getting a loan for a startup can be more challenging and may require pulling together smaller loans from several sources. Lenders evaluate factors such as your credit score, business experience, and business income when considering your loan application.

Types of Small Business Loans

Bank Term Loans

Term loans from banks provide a lump sum that you repay over a set time in fixed monthly installments. Short-term loans are generally repaid in six to 24 months, while long-term loans typically have repayment periods of three years or more. Bank loans secured by collateral generally offer lower interest rates than unsecured loans.

SBA Guaranteed Loans

The U.S. Small Business Administration (SBA) guarantees a portion of loans made by its partner lenders, reducing lenders’ risk. SBA 7(a) loans, available for up to $5 million, can be used for various purposes, including working capital or refinancing debt. SBA 504 loans, available for up to $5.5 million, have fixed interest rates and can be used to purchase long-term, fixed assets such as real estate or machinery.

SBA Microloans

The SBA’s microloan program guarantees small loans of up to $50,000 through nonprofit partner organizations. These funds can be used for business startup or expansion, with terms varying by lender. Microlenders often provide management or technical assistance to help borrowers succeed.

Other Microloans

Many community-based or nonprofit organizations offer microloans targeting borrowers who traditionally lack access to capital, such as women, people of color, or low-income individuals. Well-known small business microlenders include Accion Opportunity Fund, Kiva, and Grameen America.

Business Lines of Credit

Unlike loans that pay out a lump sum, business lines of credit offer a flexible financing option for short-term needs. A business line of credit works similarly to a credit card but typically offers a higher credit limit. You can borrow money up to your credit limit during the “draw period” and pay interest only on what you borrow. As you repay funds, they become available to borrow again until your draw period ends.

How to Get a Small Business Loan

Small business loans are available from banks, credit unions, direct online lenders, and microlenders. Follow these steps to boost your odds of success:

Check Your Personal and Business Credit Scores

Lenders typically evaluate both scores when considering your loan application. Higher credit scores may qualify you for larger loans and more favorable loan terms. Improve your credit scores by paying down debt, paying bills on time, and avoiding unnecessary new applications for credit.

Know How Much Money You Need

Determine what you’ll use the loan for, how much you’ll need, and how long it will take to repay the loan. This information helps you find the right loan size, type, and term for your needs.

Gather Required Information

Depending on the lender, you may need to provide business and personal tax returns, business bank statements, balance sheets, business formation documents, and business licenses. Some lenders require a business plan too.

Check Your Eligibility

Lenders generally have minimum requirements for credit scores, time in business, and annual revenue. Some loans also require collateral, such as real estate, inventory, or equipment, to secure your loan.

Compare Loan Offers

Many lenders let you submit information to prequalify for business loans and get estimated loan amounts and terms. When comparing loans, consider the annual percentage rate (APR), loan amount, repayment term, fees, penalties, monthly payment, and how quickly you’ll receive the money.

Alternatives to Small Business Loans

Business Credit Card

This could be all you need to finance smaller expenses. Making timely business credit card payments and minimizing credit utilization can help build a business credit history. Some business credit cards also offer rewards or useful financial management features.

Crowdfunding

This peer-to-peer financing option raises money from individuals. Popular business crowdfunding platforms include Fundable, Indiegogo, and WeFunder. Some crowdfunding sites aggregate money from individual investors to issue loans you must repay; others let you solicit donations from individuals in return for rewards such as early access to your product or service.

Personal Loans

These are widely available in amounts ranging from a few hundred dollars to $200,000 and usually don’t require collateral. Some lenders forbid borrowers from using personal loans for business; check with lenders before you apply. Unlike business loans, paying back a personal loan won’t help build a business credit history.

Friends and Family

Asking your support network to help is a common source of financing, especially for startups. Treat a loan from loved ones as you would a bank loan: Create a loan agreement and repay the loan with interest.

Accounts Receivable Factoring

Also known as invoice factoring, this is an option for established businesses that invoice clients. You sell unpaid invoices to a factoring company and receive a percentage of the invoice’s value upfront. The factor pays you the rest of the invoice (minus fees and interest) after they collect payment from the client.

Merchant Cash Advance

Businesses that accept credit and debit cards can get an advance on future payment card sales from merchant cash advance (MCA) providers. Your revenues are more important than your credit score in obtaining an MCA. However, MCAs usually involve high interest rates and daily or weekly payments.

Frequently Asked Questions

Are Small Business Loans Hard to Get?

It depends on various factors such as your credit score, business experience, and business income. Established businesses with a track record of profitability generally find it easier to get loans.

What Credit Score Do You Need for a Small Business Loan?

While there is no universal credit score requirement, higher credit scores generally qualify you for larger loans and more favorable terms.

How Much Can You Borrow With a Startup Business Loan?

The amount you can borrow varies depending on the lender and your business plan. Startups may need to pull together smaller loans from several sources.

The Bottom Line

Getting your business and personal credit in top shape can smooth your path to business borrowing. Check your business credit report and credit score, as well as your personal credit report and credit score, and resolve any issues before applying for a loan. Making payments on time and reducing debt can help improve your credit scores, which may make it easier to get the small business loan you seek. If your lender reports your account to the major business credit bureaus, making timely business loan payments will help build your business credit score, unlocking new opportunities for financing as your business grows.

For expert advice and assistance with your mortgage needs, contact O1ne Mortgage at 213-732-3074. Our team is here to help you navigate the complexities of business financing and find the best solutions for your needs.