How Do Small Business Loans Work?

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Are you ready to launch or expand your small business? Being an entrepreneur isn’t cheap — you may need to take out a small business loan. Much like any loan, a business loan is money borrowed from a lender which must be repaid, plus interest and fees, over a set period.

There are many different types of small business loans, and each lender sets its own requirements to qualify. Learn more about the loan process and decide on the financing option that best suits your needs.

When you take out a small business loan, you are borrowing money to grow or expand your business. Repayment of business loans is usually made over a set period of time with interest and fees.

The loan may be secured or unsecured. A secured loan requires you to put down collateral — an asset the lender can seize if you default on your loan. The collateral might be equipment, real estate or money. Unsecured loans often require a personal guarantee, in which you and other business owners pledge responsibility for repaying the debt.

Small businesses have access to a variety of loan options from a variety of sources, including online lenders, large banks, credit unions and peer-to-peer lending sites. Each offers a variety of loan types. 

The below common types of business loans have varying loan amounts, interest rates, fees, eligibility criteria, possible uses and repayment terms.

  • Term loans: Term loans provide a lump sum of cash that is paid back over a set period of time, typically between two to five years.
  • SBA loans: These loans, backed by the U.S. Small Business Administration, are known for having low rates and long repayment periods, but they also take the most time to apply for and qualify for.
  • Business lines of credit: Business lines of credit provide flexibility since business owners can borrow as much or as little as they need, as long as they stay within their limit. Both secured and unsecured lines of credit exist.
  • Equipment loans: Equipment loans are used specifically to buy new or used equipment, which then becomes the collateral for the loan.
  • Invoice factoring: Invoice factoring involves selling unpaid invoices to a third party in exchange for a fee.
  • Invoice financing: Invoice financing is similar to invoice factoring, but it involves selling unpaid invoices to a lender who then pays the business an advance of the invoice’s value in return for a small fee when the invoice is paid.
  • Commercial real estate loans: Real estate loans are specifically used to purchase or lease a commercial property, which then becomes collateral for the loan.
  • Microloans: Microloans are small business loans — typically under $50,000 — that are issued to businesses with low annual revenue, and they often require a personal guarantee and collateral as security.
  • Merchant cash advance: A merchant cash advance is a lump sum of cash that is paid back with a percentage of future credit card sales, and they often have higher APRs or factor rates than other business loans.
  • Franchise loans: Franchise loans are specifically used to purchase or expand a franchise.

Qualifying for a loan will depend on the lender, loan type and amount, but there are some similarities across most small business loans:

  • Credit score: All lenders consider credit standing. It is typically recommended to have a personal FICO score in the low to mid 600s, though some lenders may accept a credit score in the high 500s. Lenders may also want to see your business credit score.
  • Cash flow: Be prepared to share bank statements and business tax returns.
  • Earnings: Many lenders set a minimum annual revenue, which might be as low as $36,000 or well into the hundreds of thousands. 
  • Time in business: Banks generally prefer businesses that have been in operation for at least two years. Nontraditional lenders may go as low as six months. Startups may also find lender options but may face higher interest rates or stricter requirements in other areas.
  • Debt load: It is vital to have a decent debt-to-income ratio to demonstrate your business’s ability to repay additional debts. Businesses with too much debt will have difficulty being approved for new loans.
  • Security: Many lenders may require collateral to secure the loan. This can be real estate, equipment, cash or a blanket lien on the business.
  • Industry: Certain industries are more likely to qualify for a loan than others. Lenders look to minimize their risks, so they may refuse to lend to businesses in volatile and failure-prone industries, such as food service. Many also decline to lend to businesses related to gambling, weapons, cryptocurrency and marijuana. 

Before applying to a particular lender, research it to see whether your business will likely meet its requirements.

The bottom line

Small businesses have access to many loan options from a variety of sources. These loans work similarly to any other loan type. You’ll apply for the loan, receive funding once approved and work to repay the loan on a set schedule.

If you have a new business and you’re ready to take it to the next level, shop around and be open to different lenders, including online lenders, large banks and peer-to-peer lending sites. With so many loan programs available, it’s vital to research the requirements and interest rates before applying for a loan that best suits your needs.


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