Table of Contents
Business loans can provide borrowers with the capital they need to start a new venture, expand a business, or cover everyday operating expenses. In exchange for financing from a lending institution, businesses agree to repay the money borrowed over time, plus interest and fees.
There are many types of small business loans, each with eligibility requirements, costs, and repayment schedules. Here’s a guide to how business loans work.
Key Points
• Business loans can provide capital for startup costs and expansion, among other things.
• Repayment terms and interest rates vary among lenders.
• U.S. Small Business Administration (SBA) loans generally have the strictest eligibility requirements.
• Lines of credit can offer flexible borrowing up to a set limit.
• Online lenders provide quick funding, typically at higher rates than more traditional lenders.
What Is a Business Loan?
A small business loan is money loaned to a small business owner by a bank, credit union, or online lender. It must be repaid. The money can be used for any business-related expense that will aid the growth and continued operation of the business. Some owners need loans for everyday transactions, while others are looking for loans they can use for business expansion.
Here are some examples of what a small business loan can be used for:
• Commercial real estate
• Operational expenses
• Debt consolidation
• Equipment purchases
• Equipment repairs
• Refinancing
• Inventory purchases
• Startup costs
• Research and development
• Launching a new division or product line
• Marketing and advertising
Recommended: What Is a Small Business?
Types of Business Loans
There are various types of business loans, and it’s essential to understand how each kind of small business loan works in order to choose the best option for your business. Here’s a look at some standard small business lending options.
Small business line of credit
A business line of credit is similar to a credit card. It lets you borrow up to a specific limit and pay interest only on the money you borrow. If you take out a small business line of credit, you can draw out funds and repay them as often as you’d like as long as you don’t exceed your credit limit.
Recommended: Small Business Loan vs. Line of Credit
Accounts receivable financing
With accounts receivable financing, or invoice financing, you use your unpaid invoices as collateral to get a cash advance. Typically, invoice financing companies advance you a large portion of the value of your invoices. You receive the remaining percentage (minus fees) when your invoices are paid. This kind of financing can provide you with quick cash but can be costlier than other forms of financing.
Working capital loans
A working capital loan may be a good fit if you need just a small amount of cash to keep your business operating smoothly. However, keep in mind that repayment periods are short and interest rates can sometimes be higher than with other types of business loans.
Small business term loans
Term loans let you borrow a set amount of money that you pay back with interest on a predetermined schedule. Both long-term and short-term small business loans may be available. The type that will work best for you will depend on your business’s needs. A small business loan calculator may help you assess and compare possibilities.
SBA small business loans
These loans are offered through a lender partly insured by the U.S. Small Business Administration (SBA). Should the borrower default, the SBA will repay the lender most of the debt. Because SBA loans are government-backed, they typically come with lower interest rates and better terms for borrowers. However, they can be hard to qualify for.
Equipment loans
You might consider equipment financing if you want to purchase a new piece of equipment or machinery. With this type of small business loan, you typically get an option for the equipment you’d like to buy, and a lender fronts you a significant portion of the cost. The asset you purchase with the loan acts as collateral for the loan.
Small business credit cards
A business credit card is similar to a personal credit card, except it may provide reporting features to categorize and track your spending and a rewards program to help you save on typical business expenses. Some 0.00% annual percentage rate (APR) credit cards offer no interest for a fixed period (often longer than a year).
Secured vs. Unsecured Business Loans
Business loans may be secured or unsecured. With secured loans, the borrower provides some kind of collateral – real estate, bank accounts, or other assets – that the lender may lay claim to if the borrower defaults. Generally, a secured loan comes with more favorable terms for the borrower since it may reduce risk for the lender.
Recommended: Guide to Small Business Financing
How to Find the Right Business Loan
There are many kinds of loans on the market. To find one that meets your needs and qualifications, even if your company is a business startup, here are some essential points to consider.
Requirements to Qualify
Understanding a lender’s minimum requirements and qualifications can increase your chances of getting approved for a small business loan. While some lenders may be flexible, many require that borrowers meet a minimum credit score, annual revenue threshold, and required number of years in business.
Loans backed by the Small Business Association (SBA) tend to have the strictest requirements, while small business loans from direct online lenders and peer-to-peer lending sites are often less stringent.
Key Terms to Know
When you’re asking yourself “how do business loans work?” It’s important to understand a few common business loan terms.
• Repayment term: This is the amount of time a borrower has to repay the loan.
• Fees/penalties: These are extra costs in addition to the interest the borrower may need to pay, such as application fees, origination fees, and late fees. (The loan agreement usually lists all small business loan fees.)
• Eligibility requirements: These are the conditions the bank or lender requires the borrower to meet in order to qualify for financing.
• Interest rates: This is essentially what the lender charges the borrower for giving them access to the money, usually expressed as a percentage of the loan amount.
• Principal: This represents the total amount of money borrowed (not including interest).
• Time to funding: This refers to how long it will take for the lender to distribute funds to the borrower.
Matching Loan Type to Your Business Goals
As you’re looking at different kinds of loans, you’ll want to bear in mind not only which ones your business can meet the requirements for, but also what loan types match what you’re trying to do. For instance, if you need new computers for your software as a service business, equipment financing might be a good choice. If you have a seasonal business and need to have funds ready to cover your slower seasons, you might want to have a line of credit available to use if and when you need it. And if you’re interested in developing a new product or are planning a specific project to improve your business, a term loan may help you get the lump sum you need to move forward.
Recommended: What Is Business Banking?
Types of Lenders That Offer Business Loans
There are a variety of lenders who may provide loans to small businesses. Each has its own requirements and processes. Here are some of the most common types to be aware of.
Direct Online Lenders
You can apply directly with an online lender instead of working through a traditional bank. The benefit of doing this is that many online lenders have advanced technology to approve borrowers quickly and transfer funds. A potential drawback is that it’s not uncommon to get charged higher rates by a direct online lender than by a traditional bank.
Large Commercial Banks
Large commercial banks are known for issuing loans with lower interest rates than other kinds of lenders, but the drawback is that they tend to have strict qualification requirements that can be difficult to meet. Large commercial banks may be outside your reach if you’re a new business.
Large Community Banks
Community banks are locally owned and operated. Since they tend to be smaller than commercial banks, they can often provide borrowers with more individualized service. These banks may also look at other aspects of a business besides its credit score.
Peer-to-Peer Lending Sites
With peer-to-peer lending sites, any money you receive comes from a group of investors instead of a single lender or a bank. Peer-to-peer loans are often easier to qualify for but tend to cost more in the long run due to fees and higher interest rates.
SBA-Backed Banks
The Small Business Administration partially backs SBA loans. Since they present less risk to the lender, these loans tend to have lower interest rates and longer terms. However, they also typically have strict eligibility requirements.
Credit Unions and Community Development Financial Institutions (CDFIs)
Credit unions are member-owned not-for-profit financial institutions, while community development financial institutions (CDFIs) are community-based financial institutions certified by the U.S. Treasury. Both kinds of institutions are mission-driven and may make loans that are more favorable andor easier for minorities, women, and other disadvantaged groups to access than traditional lenders’ products. Bear in mind that to participate in a credit union, you’ll need to be a member.
How to Compare Lender Offers
All business loans are not created equal. Here are some things to consider when comparing business loans.
Interest Rate Need-to-Knows
Some loans have fixed interest rates, while others have variable interest rates.
A fixed business loan has a set interest rate that remains unchanged over the loan’s life. Your loan payments will be the same each month until the loan is paid off.
An adjustable-rate business loan starts with a set interest rate that starts changing based on current market rates at a predetermined date. After that date, your monthly payments could rise or fall.
Before choosing what kind of rate you want, it can be a good idea to research average small business loan interest rates.
Recommended: Fixed vs. Variable Rate Business Loans
Early Payment Penalties
Some lenders charge a prepayment penalty if you pay off your loan early, while others do not. A loan with higher interest rates but no prepayment penalties could be a better deal for you if you think there’s a high chance you will want to pay the loan off early.
Late Payment Penalties
Before you sign a business loan contract, it’s practical to find out what the fee is for making a late payment. You’ll also want to know how long you have before you’re charged a late payment fee.
What Does the Lender Consider a Default?
It can be a good idea to determine what a potential lender considers a loan “default.” Sometimes, it takes only a slight cash flow change to potentially jeopardize your business. Of course, if you’re ever in danger of defaulting, you should speak with your lender early on, as they may be able to help.
Applying for a Business Loan
After you find a loan you are interested in, the next step is filling out an application.
Once you have all your documents in order, how exactly you’ll need to apply for the small business loan will depend on the lender. With online lenders, you can typically do everything (not surprisingly) online. However, more traditional financial institutions like banks and credit unions may require you to apply in person at a branch office or over the phone.
Either way, double-check that your business loan application includes everything the lender requested in the appropriate format. This can help reduce any unnecessary back-and-forth so you can get a decision as quickly as possible.
Documents You May Need to Provide
When you apply for a small business loan, you typically need to provide the following paperwork:
• I.D.
• Bank statements
• Proof of ownership
• Balance sheet
• Personal tax returns
• Business tax returns
• Profit and loss statements
• Voided business check
What to Expect After You Apply
After you apply for your business loan, you’ll need to wait for the lender to review your application and verify your information and creditworthiness. How long this will take will depend on the kind of lender and loan you opted for. Most lenders can give you an estimate of a typical timetable in advance so that you’ll have a sense of how long you’ll need to wait for an answer.
Recommended: Best Cities to Start a Business in the U.S.
The Takeaway
Business loans are a form of credit that may be offered by lenders to businesses. In exchange for this money, lenders require repayment of the principal with interest and fees added.
Usually, business loans require the borrower to make regular payments on a set schedule, but repayment terms and interest rates can vary depending on the lender and your business’s qualifications.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How much income is needed for a business loan?
It depends on the lender and the amount of the loan. Lenders typically look at a company’s income (as well as its available cash) to ensure that the business will be able to repay the loan.
What are the rules for business loans?
The rules (or terms) will depend on the loan. Monthly payments, interest rates, and repayment periods all vary and will be listed and explained in your loan contract terms, but you should also be able to speak with your loan manager if you have any questions.
How do you pay back business loans?
Term loans typically require monthly payments. If a loan is very short-term, you may be required to make weekly payments. Most loan payments can be made online or over the phone.
How long are business loan terms?
Intermediate and long-term loans often have repayment periods between two and 10 years. If you take out an SBA loan, you may even have as much as 25 years to pay off the loan in some cases.
Can you get a business loan with no down payment?
Yes, some loans allow you to put up collateral instead of making a down payment.
Photo credit: iStock/nortonrsx
SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
SOSMB-Q126-051