How Do Small Business Loans Work?

Whether your small business is getting ready to make a big purchase, must navigate some unexpected financial challenges, or just wants to manage cash flow more efficiently, a small business loan can help. 

Small business loans may be an efficient and effective way to help build a rainy day fund, grow your business, or improve your operations. However, navigating the seemingly endless loan options available to your business can be overwhelming. 

Here, we’ll help any entrepreneur understand the best small business loans in the context of your small business needs, the types of loans available to your small business, the small business loan application process, and what lenders will look for in your small business application process. We’ll cover the following topics in depth in this article: 

Types of Small Business Loans 

There are many types of small business loans, ranging from the type of lender to the purpose of the loan. Each has varying repayment terms, interest rates, repayment periods, and more. These are some of the most common small business financing types. 

SBA Loans

SBA loans are loans that are partially backed by the U.S. Small Business Administration (SBA). SBA backing makes the loans safer for SBA lenders and, therefore, cheaper for qualified borrowers. Some requirements include: 

• Your small business has unsuccessfully sought other financing options. 

• The applicant has a serious stake in the business. 

• The business is for-profit. 

• The business will use the loan only for legal, approved expenses. 

• Operating in the United States of America. 

The advantage of SBA loans is that they can be used for a variety of business purposes. If you are going to be making any large real estate purchases, have any upcoming construction projects, need a line of credit for working capital reasons, or something else, you can get an SBA loan to provide you with a lump sum of cash. 

Programs like the SBA 7(a) loan program provide reduced interest rates and restrictions on prepayment penalties. Borrowers love SBA loans, but they can be hard to get. You do have to be in business for some time and show that you have failed to get financing from other lenders first. 

American banks and other lenders offer SBA loans. The SBA guarantees a part of the loan, making the loans more affordable for banks and financial institutions. 

Term Loans

Term loans are just like they sound. Banks, credit unions, and online lenders offer businesses a variety of term loans in the form of lump sum payments. 

Term loans can be used for a variety of purposes and may have repayment schedules of several years with fixed rates. Additionally, you can sometimes get low interest rates and favorable terms on bank loans for your small businesses. 

Getting a term loan, however, may be cumbersome. Your small business will need to have a good credit history, strong financial reports, a cogent business plan, and other documents that reflect its profitability and likelihood of correctly managing the debt it is taking on. 

Business Lines of Credit

Lines of credit can be a helpful tool for your small business. If you are trying to maintain or improve the cash flow level of your business, a line of credit is a unique type of loan that appears similar to a credit card. 

When your small business receives a line of credit, you have a maximum loan amount from which to draw down on. This means you are guaranteed an amount that you can borrow from a lender as you go along with your small business affairs. If your small business runs into problems with unexpected expenses, you can draw down the line of credit. You’ll only be charged interest on the amount you draw, not the entire loan amount. 

Business lines of credit are usually revolving, which means when you pay back the amount you’ve drawn, you’ll have access to the full amount again. 

Business lines of credit are available from both banks and online lenders (like Biz2Credit) and have variable interest rates. Alternative lenders can usually offer your small business quicker access to a line of credit than a traditional bank. Since they’re easier to qualify for than traditional loans, business lines of credit may be good solutions for startups. 

Short-Term Loans

If you need to access a lot of capital quickly for your small business, short-term loans can help. For example, if you are running a small trucking business, one of your trucks might have a major part break that needs to be replaced quickly.

Sometimes known as working capital loans, short-term loans can be processed in as little as a day and usually have a repayment period ranging from three months to two years. Rather than paying interest on the loan, these loans usually carry a fee. That way, as a small business owner, you know what you are getting yourself into in terms of costs right away. 

Short-term loans can be expensive. However, they might be the right choice for your business so that your business can continue generating revenue even if you experience a minor problem. Waiting to input capital can sometimes take too long. 

These may also come in the form of microloans, which are loans for less than $500,000 with short repayment terms. 

Equipment Financing

Equipment financing, or equipment loans, are small business loans used to purchase new equipment. From small businesses in the food industry to manufacturing, agriculture, and more industries, equipment is often essential to operations.

It’s also expensive. Many small businesses do not have the cash flow necessary to fund a one-time, all-upfront purchase of equipment. Equipment financing allows a small business to make an initial down payment and monthly payments on the remaining balance. Spreading the cost out over time can make an equipment purchase much more affordable for a small business.

Interest rates for equipment financing are often very low because the equipment that the small business purchases with the loan is used as collateral. If the borrower ends up defaulting, the lender can take the equipment as collateral and essentially insure themselves against losing money.

The Small Business Loan Application Process

The small business loan application process may vary between lender and loan type. We break down the general process below.

Determine the Right Loan for Your Small Business

The most important first step before seeking a loan is to determine your small business’s needs. Before you get a loan, you must have a well-reasoned plan for the capital. Theoretically, this debt only makes sense if you expect to have a better use for your current cash flow or if not taking out the loan would make your operations less profitable.

Once you know why you need the loan, it will inform what type of loan and how much money you need. If you just need an increase in cash flow to get through an expected temporary lull, a working capital loan or business line of credit may work. If you’re looking to expand into a new market aggressively, you may want to explore term loans.

Shop Lenders

Once you have determined the type of small business loan that your small business is interested in, it’s time to start shopping for lenders. You can do this by searching online for your ideal loan and locating the type of firm you are looking to lend from. This might be banks, credit unions, or other alternative lenders.

When you’re shopping online, you can enter some information to get estimates of the amount of a loan you qualify for, your likely interest rate, and the relevant terms. Getting this early estimate allows you to then be confident in shopping around for that commercial real estate, equipment, or construction project that your small business needs. 

Apply for the Loan

When you formally apply for the business loan, you will likely include the purpose of your loan, information about you and your business, and key financial metrics, like annual reports and undergo a credit check. This information will allow the lender to estimate your small business's financial capabilities to repay the loan.

Verification and Loan Underwriting

After you’ve applied, you’ll enter the verification and loan underwriting process. Essentially, this means that you and your small business will need to have the veracity of the information that you provided on your application assessed.

The lender requests a host of documents, including documents related to your identification, your credit history and the credit history of your small business, your bank and credit card statements, financial statements, tax returns, and more. This is the verification process.

The underwriting process is where the lender then uses this information to give you a final offer. They will write up a contract for you and your small business to accept. You should check these details and be certain that you are okay with the conditions of the loan, as the terms and conditions of the loan may have changed since you made an initial offer at the prequalification stage.

Funding

Once you have signed your lending offer, the loan is yours. The transfer to your small business bank account can happen as soon as one day. You should coordinate with your lender to understand what details you can provide them with so that you can receive the business funding necessary as quickly as possible.

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Eligibility Requirements for Small Business Loans

Different lenders and loans have different eligibility requirements. Nonetheless, these are the most common qualifying considerations that lenders take into account.

• Credit score: Your personal credit score and business credit score may be factored into your lender’s decision-making. Typically, you’ll want a credit score of at least 600.

• Business revenue: Since your small business is trying to get a loan, your annual revenue will play a role in their decision. The higher your revenue, the less risky your business.

• Collateral: Especially for larger loans on real estate, equipment, or other big purchases, collateral like personal assets, equipment, or property will help secure the loan.

• Time in Business: Lenders want to be sure that your small business will continue to stay in business and generate revenue to pay back the loan amount that you are given.

Conclusion

Loans are often an essential resource for small businesses. They can be the gateway to growth and expansion, the stopgap to fill a cash flow shortage while you wait for accounts receivable to be paid, and so much more. Before taking out any loan, you want to make sure you fully understand exactly what you are agreeing to and what the terms and conditions are.

Knowing how small business loans work is a vital part of running a company. While this post only scratches the surface of small business loans, how they work, and what is available to you, it can serve as a great launching pad. A small business loan could end up being just what your business needs in the very near future!

FAQs

1. How many types of business loans are there?

   There many, many types of small business loans available to entrepreneurs and companies. Some of the most common include term loans, SBA loans, working capital loans, commercial real estate loans, business lines of credit, and equipment financing loans. Different types of loans are used for different business purposes. 

2. How do you get a small business loan?

   To get a small business loan, you must apply for funding. Depending on the loan type and lender, this could just take a few minutes online, or it may have a more involved verification and underwriting process. Generally speaking, larger term loans from banks and credit unions will have more involved application and underwriting processes while short-term loans like business lines of credit or working capital loans may have a less involved process. To get a loan, you must first determine what you’ll use the money for and how much you need. Then, compare lenders to find the right match for you, then apply. 

3. What do you need to qualify for a small business loan?

   Different types of loans have different eligibility requirements. For instance, term loans usually require the business to be operational for at least two years, have demonstrated revenue history, and a business owner credit score of at least 600. SBA loans typically have a minimum credit score of at least 650.

   Short-term loans or bad credit business loans may have less stringent requirements and be more suitable for startups, but they often come with stricter repayment terms and higher interest rates.