Business loans provide borrowers 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 provide capital for startup costs and expansion.
• Repayment terms and interest rates vary among lenders.
• SBA loans have the strictest eligibility requirements.
• Lines of credit offer flexible borrowing up to a set limit.
• Online lenders provide quick funding, typically at higher rates.
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 for business expansion.
Here are some examples of what a small business loan can be used for:
• Commercial real estate
• Operation 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
Types of Business Loans
There are various types of business loans, and it’s essential to understand how each works 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. You can borrow up to a specific limit and only pay interest on the money you borrow. If you take out a small business line of credit, you can draw funds and repay them as often as you’d like if you don’t exceed your credit limit.
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 percent (minus fees) when your invoices are paid. This 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 just need 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’s paid back with interest on a predetermined schedule. Both long-term and short-term small business loans are available. Which type will work best for you will depend on your business’s needs.
SBA small business loans
These term loans are offered through a lender insured by the SBA. Should the borrower default, the SBA will repay the lender most of the debt. Because SBA loans are government-backed, they 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 a quote for the equipment you’d like to buy, and a lender will front 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% APR credit cards offer no interest for a fixed period (often longer than a year).
Recommended: Business Term Loans: Everything You Need to Know
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 yours is a business startup, here are some essential things 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, and number of years in business.
Loans backed by the U.S. 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 how do business loans work, it’s important to understand a few key business loan terms. Here are a few to become familiar with.
• Repayment term: the amount of time a borrower has to repay the loan.
• Fees/penalties: extra costs in addition to the interest you 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: conditions the bank or lender requires the borrower to meet to qualify for financing.
• Interest rates: what the lender charges for giving you access to the money, expressed as a percentage of the loan amount.
• Principal: the total amount of money you borrow (not including interest).
• Time to funding: how long it will take for the lender to distribute funds to the borrower
Types of Lenders That Offer Business Loans
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. The drawback is that it’s not uncommon to get charged higher rates when working with a direct online lender than a traditional bank.
Large commercial banks
Large commercial banks are known for issuing loans with lower interest rates than their peers, 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 you with more individualized service. These banks may also look at other aspects of your business besides your 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 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.
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 changes based on current market rates at a predetermined date. After that date, your monthly payments could be more or less.
Before choosing which one you want, research average small business loan interest rates.
Recommended: Fixed vs. Variable Rate Business Loan
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 if you think there is a high chance you will pay the loan off early.
Late payment penalties
Find out what the fee is for making a late payment. How long do you have before you’re charged a late payment fee?
What does the lender consider a default?
It’s a good idea to determine what a lender considers a loan “default.” Sometimes, it only takes a slight cash flow change to potentially jeopardize your business. Of course, if you are ever in danger of defaulting, it’s always a good idea to speak with your lender early on, as they may be able to help.
Applying for a Business Loan
Once you find a loan you are interested in, the next step is filling out an application. 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
Once you have all your documents in order, how you’ll 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 at a branch 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.
Recommended: Best Cities to Start a Business in the U.S.
The Takeaway
Business loans are a form of credit 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 interested in finding out what type of loan you may qualify for, Lantern by SoFi can help. With our easy-to-use online tool, you can learn about an offer from a small business lender without obligation.
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 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 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 three and 10 years. If you take out an SBA loan, you may even have 25 years to pay off the loan.
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
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