5 Things Borrowers Need to Know About How Small Business Loans Work
Studies have shown that 20% of small businesses fail in their first year, 30% in their second year, and 50% by year five. 70% of small businesses don’t make it past their tenth birthday.
A financial hurdle is one of the most common reasons these businesses fail. It is therefore important for Small business owners and startup founders to take business financing seriously in order to meet their business needs from time to time.
This is why we are going to access 5 things borrowers need to know about how small business loans work:
- What is a business loan?
- What can you use a business loan for?
- Types of business loans.
- How to apply for a business loan.
- Where to get a business loan.
1. What is a Business Loan?
A business loan, as the name implies is a kind of loan that is made available to businesses and business owners. It is a type of commercial financing option provided to businesses for the sake of sustaining and expanding operational capacity. Every business stage needs one form of financing or the other.
Cash flow is said to be the blood of a business, without which a business will not function. It is not uncommon for businesses to run out of cash, hence, the need for a business loan.
A business loan can be paid back with a fixed interest rate or a floating interest rate. In the case of a fixed interest rate, the loan has a fixed annual percentage rate over the loan repayment period while for a floating interest rate, the annual percentage rate fluctuates over the repayment period. The type of interest rate depends on the loan option a business owner decides to go for.
The payment plan for a business loan can be different depending on the agreement the borrower has with the lender. The loan could be repaid through a monthly payment plan, quarterly payment plan, or the repayment plan can be entirely stipulated and planned out by the lender. There are a range of different options, which the borrower often has a choice or say in as well.
There are different types of business loans, which will be explained later in the article, but broadly speaking, we can classify business loans into two types:
A loan is classified as a secured loan when a lender requires an asset from the borrower before granting access to credit. Assets in this case could be real estate property, machinery, stock, etc. If a borrower defaults on the business loan repayment for a significant period, the borrower is at risk of losing the asset.
A loan is classified as an unsecured loan when a lender doesn’t require any form of an asset from the borrower before granting access to credit but can request a personal guarantee from the borrower. This poses a higher risk to the lender; hence, this type of loan often has high-interest rates compared to secured loans. Unsecured loans require the borrower to have a good credit rating, and the loan amount is relatively low.
2. What Can You Use a Business Loan for?
Businesses take out loans for various reasons, some of which are listed below:
- Startup Cost – setting up a new business
- Operational Expenses
- Asset Purchase
- Inventory Purchase
- Business Acquisition
- Business Expansion
- Employee Training and Onboarding
- Marketing and Advertising
3. Types of Business Loans
SBA – Small Business Administration Loans are offered by banks and partially insured by the U.S. Small Business Administration. SBA loans typically range from $5,000 to $5 million and come with extended repayment terms — up to 25 years. This loan can be used for any business-related expenses as seen fit by the business owner. These expenses can range from operations-related expenses to business expansion.
Business Line of Credit
You can see a business line of credit as a non-physical business credit card although there are discrepancies. A business line of credit gives a business owner an opportunity to draw from a line of credit on a need basis especially when you don’t know the amount needed upfront.
Another interesting part is that you can reuse your credit limit as you repay it throughout the draw period, and you’ll only owe interest on the amount you borrow — not the entire approved limit.
Unlike business credit cards, a business line of credit’s draw period eventually expires, typically within 12 to 24 months. Once the draw period ends, the repayment period begins, and you’ll have to repay any unpaid balances, plus interest. The repayment period can range anywhere from six months to five years. During this time, you’ll no longer have access to your credit limit for borrowing purposes.
A term loan is another common type of business loan that is offered for a specific period. A term loan can be a short-term loan or a long-term loan. A short-term loan can be used to cover smaller and immediate expenses with a repayment period of up to 18 months. A long-term loan usually has a loan term of up to 10 years with a fixed interest rate.
This is a business-to-business agreement (B2B) in which a customer can purchase goods without paying cash upfront. The customer, in this case, is a business that needs inventory, the business owner gets these goods from a wholesaler on credit with an agreement to pay later.
Inventory financing comes in the form of a short-term loan or line of credit and is specifically designed to cover inventory costs. Inventory typically acts as collateral on the loan or line of credit and the lender would finance up to 80% of the inventory value. Inventory financing may come with high-interest rates and terms are usually short, requiring daily or weekly repayments.
Merchant Cash Advance
A merchant cash advance (MCA) can be an easy way to access short-term financing when your business needs money fast. Business owners give the lender—often a merchant services company—a portion of future sales receipts in return for a lump sum of cash. This amount plus fees are repaid from the business’ individual sales or through automatic clearing house (ACH) payments on a daily or weekly basis. MCAs may be a good option for businesses that experience a high volume of sales and need to access cash quickly—without qualifying for a traditional business loan.
Working Capital Loan
A working capital loan is a loan that is taken to finance a company’s everyday operations. A working capital loan is a business loan to cover normal operating expenses especially when there is a shortfall in revenues versus expenses. Businesses can consider a working capital loan in the following situation: seasonal revenue fluctuation, unforeseen expenses, business growth, buying inventory, inconsistent cash flow, and equipment purchase.
4. How to Apply for Business Loans
The most fundamental thing a business owner should consider while making the decision to take out a business loan is what the loan will be used for. Knowing what the business loan will be used for will inform the type of loan to take out, the repayment plan to opt for, the interest rate to shoulder, and the repayment period.
Different lenders have their own loan application process but you can find some of the requirements below:
Lenders are in business because of profit. As such, they are looking for borrowers who are creditworthy. That said, good credit is often relative. Some lenders may consider certain credit scores as good while other lenders may view the exact same score as too risky for them. It is therefore important to know the minimum required business credit score for any type of loan and lender you want to go for. Of course, there are certain credit scores that are considered bad or low by almost all lenders, so that is something you should consider as well.
The purpose of your business plan is to show lenders what you want to use the loan for. Running a business is risky and the lenders are aware of it, therefore, most lenders request a business plan for a business loan. Your business plan will help convey the purpose of your loan and how you believe it will help you become more profitable. When creating your business plan, make sure to include the following information:
- Executive Summary
- Business description
- Product or service description
- Market analysis
- Management team
- Sales and marketing strategy and implementation
- Financial plan and projections
As much as your business plan is important, lenders also want to see the financial statement of your business, they want to know your annual revenue, operating expenses, accounts receivable, payables, etc. hence, you may have to provide your income statement, balance sheet, cash flow statement and statement of financial position.
For most business loans, especially secured loans, lenders will request collateral just in case of default. Collaterals are usually assets like real estate property, machinery, account receivable, stock, etc.
Lenders often review bank statements while accessing credit requests. They use the business’ bank statement to understand the financial health of the business as well as the credit history of the business.
In some cases, lenders require a personal financial commitment from the entrepreneur. This means that in case the business cannot pay back the business loan, the entrepreneur will have to take responsibility by paying back the loan personally. Therefore, the lender will also access the entrepreneur’s bank account, credit report, personal credit score, personal assets, etc. If the entrepreneur has a bad credit score based on the lender’s standard, the business may be at a disadvantage.
5. Where to get a business loan
Commercial Banks and Financial Institutions
Commercial banks offer consumers and small to mid-sized businesses with basic banking services including deposit accounts and loans. They have traditionally been located in physical locations, but a growing number now operate exclusively online. They are important to the economy because they create capital, credit, and liquidity in the market.
While large commercial banks have rigorous requirements for small business loan borrowers, they have the power to offer larger loans than other lenders, which can be very helpful when you’re growing your business.
There are also banks and financial institutions that are backed by SBA – Small Business Administration.
There are many direct online lenders like Biz2Credit who offer loans directly to small business owners. They make use of powerful algorithms and technology, therefore, credit requests are processed faster. This may be the best route for you if you need quick cash.
A community bank is a depository or lending institution that primarily serves businesses and individuals in a small geographic area. Community banks tend to emphasize personal relationships with their customers. They are locally owned and managed. They operate at a local level and are relatively small to commercial banks.
Peer-to-Peer lending Sites
There are online platforms where you can be connected to lenders and investors. P2P lending sites act as the middleman between you (the borrower) and the investors. It can match your loan request with investors’ funds. Investors that lend to you will receive the interest you pay on the loan minus the lending site’s fee.
Many small business owners can be hesitant about taking out a small business loan, and that is understandable. Loans come with a lot of obligations, and they can be confusing at first. However, loans can enable you to take your business to the next level by providing you with the working capital and resources you need. As a result, loans are something every small business owner should at least understand if not consider. So, keep researching and learning more about them – you might want to take one out in the near future.
To keep learning more about small business financing and all the offerings that exist, please be sure to keep checking back here at our Biz2Credit Blog for all the latest information and news on small business financing and small businesses in general!