A business loan is a financial asset that can help cover the cost of an unexpected expense, purchase an expensive piece of equipment, lay the foundation for expanding your business, or solve a sudden cash flow problem. Seeking a business loan will require preparation and legwork, including research on the type of loan that’s best for you.
Here’s what you need to know about different types of business loans and how to prepare to apply for one.
What types of business loans are available?
Choosing the type of loan that best suits your needs and repayment ability is essential. You should take out a loan with the idea that it will help your business, not saddle you with debt.
Line of credit loan
This short-term loan is considered a useful option for small businesses. With a line of credit, you’re given a certain amount of cash which you can draw from. You only repay the amount you draw and that’s the only amount you pay interest on.
Term loan
This type of loan is the one with which most people are familiar. It comes in both short- and long-term options, with generally lower interest rates for longer-term loans. Borrowers receive a lump sum of cash upfront and make monthly repayments of principal and interest. These loans have some of the lowest interest rates and generally require collateral.
Specialty financing
Specialty financing includes loans for very specific purchases, such as leasing or buying equipment. You usually pay equipment loans over the estimated lifespan of the equipment you’re financing, and the equipment serves as collateral. Specialty financing also includes commercial real estate loans. The main issue with these loans is that sometimes the loan outlasts the life of the equipment.
Invoice financing
With invoice financing, you use unpaid invoices as collateral to secure a cash advance, which is usually equal to a percentage of the invoice. You then repay the advance once the invoice is paid, along with a fee. A similar type of financing is invoice factoring, where you sell your outstanding invoices to a factoring company for it to collect on.
Merchant cash advance
Like a payday loan, a merchant cash advance is an expensive form of borrowing where you get a cash advance in exchange for a percentage of your future credit card sales. Because these loans are short, and repayment is taken out daily, they can have the equivalent of a 70-200% APR. The upside is that these loans are very quick and easy to obtain.
Personal loan
If you have a very strong personal credit score but have a new business or limited collateral, you might consider taking out a personal loan for business expenses. Keep in mind, though, that if you default on the loan, it will impact your personal credit.
Secured and unsecured loans
To receive a secured loan, you must provide collateral. The collateral, such as real estate or inventory, must outlast the loan. The advantage of a secured loan is that it usually has a lower interest rate than an unsecured loan.
Unsecured loans generally have a higher interest rate because the borrower does not have collateral to be claimed by the lender if the borrower defaults on the loan. You will only be able to receive this type of loan if the lender considers you to be low-risk. That generally means that your company has been profitable and the lender considers your business in sound condition.
How do Small Business Administration loans work?
The governmental body known as the Small Business Administration (SBA) doesn’t directly loan money to small business owners. Instead, it works with partner lenders to make it easier for small businesses to get loans.
The SBA guarantees a portion of the loan, meaning if the borrower defaults, and the lender can’t recoup its costs from the borrower, the SBA will pay that amount. This makes the loans slightly less risky for a lender, which in turn improves the likelihood of approval to a borrower it may not have otherwise approved.
The advantages of SBA-guaranteed loans are long borrowing terms, low interest rates, and high borrowing amounts. Another plus is that some of these loans will offer support to help borrowers run their businesses successfully.
SBA-backed loans can range from $500 to $5.5 million dollars and can be used for almost any business need. Generally, they require lower down payments, and collateral isn't always needed.
To qualify for an SBA loan, the business must be physically located and operate in the United States or its territories. It must also be officially registered and a legal entity.
To apply for an SBA loan, you must provide a statement of purpose, a business plan, and financial statements, including a cash flow statement, income statement, balance sheet, and personal financial statement.
To increase the odds of getting a loan, it’s essential that you establish a business credit profile as soon as possible.
Steps to take before you apply for a business loan
1. Understand your options.
Applying with the right lender is as important as choosing the right business loan. When researching your loan options, look into banks and other lending institutions that offer business loans. While large banks can fund more significant loan amounts, alternative lenders may provide quick approvals and have less stringent funding requirements. Working with a local bank also allows you to develop a rapport with the lender. Having that personal connection can afford you more flexibility in the future.
[Read more: A Breakdown of Business Loan Types]
2. Build/maintain good credit.
One of the first things a lender will look at when determining whether to approve you for a loan is your credit score. Your credit score is a snapshot of your lending history, including how many lines of credit you have open, if you pay your bills on time, and if you’re using your current credit responsibly and effectively. Other factors lenders may consider when reviewing your business loan application include:
- Your experience in your industry.
- How long your company has been in business.
- Your company’s reputation with your customers and other industry competitors.
If your business is relatively new, a large bank is less likely to approve your business loan application, and alternative lenders and local banks may ask to see your personal credit score to help inform their decision. However, even if you don’t qualify for a business loan, you may be eligible for a business line of credit, which you can use to help build and improve your business credit score, helping you secure larger business loans in the future.
3. Prepare your documents.
Good financial records become especially important when applying for a business loan. Your bookkeeping and accounting processes should include tracking your assets, revenue, debt, and expenses. For a business loan, you’ll need to provide proof of cash flow and accurate financial projections. Lenders will want to see your financial reports and realistic forecasts with the loan factored in to accurately estimate your business’s future revenue and expenses.
Once you have your financial documents in order, you can determine how much you’ll need for your business loan. If your loan sum exceeds what you need, you could wind up paying unnecessary accumulated interest. On the other hand, if you request too little, you might need to apply for an additional loan, which will come with its own interest rate and payment plan..
When you have your loan estimate, review the potential loan terms against your business’s other financial obligations to determine what you can actually afford. If your loan estimate is more than you can afford, consider lowering your loan estimate or seeking a different loan option.
4. Follow best practices.
Making a mistake in the application process could prove costly for your financial future. Some best practices to keep in mind include:
- Think like a lender. Once you’ve completed your loan application, review everything from a lender’s perspective to ensure you’ve provided everything they would want to see in order to approve your loan. Your application is your chance to prove yourself a competent borrower.
- Be prompt and thorough. If a lender requires additional documentation, send it as soon as possible. Banks and lenders review many loan applications, and prolonging the application process may affect their decision to approve your loan. Provide more information than what the bank asks for if you can, so you can avoid delaying the process by having to provide additional documentation
- Be accurate. Like applying for a job, padding your loan application may negatively affect your chances of getting a loan. Banks and lenders want to work with borrowers they can trust. So, review your financial documents carefully to ensure they accurately reflect your business’s finances, and its earnings and growth potential.
Is a loan your best option?
You need to decide if you really need a loan or if your main issue is related to cash flow. If cash flow is what’s causing the financial difficulties, you may be able to figure out a way to accelerate your receivables, even if that means offering customers a slight reduction in price for paying their bills early.
Decide if a loan will help you achieve the goals in your business plan. If you don’t already have a business plan, write one. A formal business plan will give you a better idea of what you need to accomplish with a potential loan and how large a loan you need. It’s an important step because most lenders will require a business plan if you decide to pursue a loan.
[Read more: How to Write a Business Plan]
Questions lenders will ask
Since lenders are also business people who need to make a profit, the first question you’ll get is, “Can you repay the loan?”
Lenders will determine this about you by reviewing your credit history and financial statements.
The three main criteria lenders use to decide whether to approve you for a loan are:
- Your personal credit score.
- Your time in business.
- Your annual revenue.
Depending on the lender — for example, a traditional bank versus an online lender — some factors will be more important than others.
Young companies may have a harder time securing a loan because they don’t have a track record. To increase the odds of getting a loan, it’s essential that you establish a business credit profile as soon as possible.
Lenders will also question if you have a backup plan if your reason for obtaining the loan is unsuccessful. For example, if the loan is to fund a project designed to increase revenue, and that doesn’t happen, they’ll want to know if you can still make your regular loan payments.
Before applying for a loan, try to get your credit score in the best shape possible. Also, start gathering the paperwork you’ll likely need, including:
- Business financial statements, like a current profit and loss statement from the last three fiscal years, a cash flow statement, and your balance sheet.
- Bank statements from the last three months.
- Personal and business income tax returns for the last three years.
- Ownership and affiliations, including any other business you have a financial interest in and any partners in your business.
[Read more: 2023 Small Business Financing Trends]
Borrower beware
As in any business transaction, you must be sure that you are being treated fairly. Watch out for these lending practices:
- Lenders who impose unfair terms on borrowers, either by deception or coercion.
- Interest rates that are significantly higher than those offered by competitors.
- Fees that are more than 5% of the value of the loan.
- Being asked to lie on the paperwork.
- Being told to leave signature boxes blank.
- Being pressured into taking a loan.
Before finalizing a loan agreement, consult an attorney, financial planner, or accountant to determine when you need the money and how much you need.
This story was updated by Julianna Lopez.
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