How does a small business loan work?

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Small business owners in search of startup capital may find that a business loan is the best means for getting their business off the ground. In this guide, we'll go over the basics of small business loans, including how to get a loan and what types of financing options are the most common.
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If you’re looking to start a new business or grow an existing business, you might consider getting a small business loan. Small business loans provide access to capital you can invest in your business. But before you apply for a small business loan, it’s important to understand what these loans are and exactly how they work.

What is a small business loan?

A small business loan allows small business owners to borrow money from a lender and use the capital for company expenses. Business loans are often used to start a business or purchase inventory, but there are a variety of use cases for small business loans.

Unlike other types of loans, small business loans must be used for business purposes. Most small business lenders have additional eligibility requirements that business owners must meet to secure financing.

How do business loans work for a small business?

Small business loans are a way for entrepreneurs to secure capital from a lender. Some of the uses for a business loan include:

  • Start a new business
  • Expand an existing business
  • Acquire another business
  • Purchase commercial real estate
  • Purchase business equipment or inventory
  • Run marketing and advertising campaigns
  • Pay off business debt
  • Cover unexpected business expenses

Small business loans function much like other loans. The lender agrees to give you a specific amount of money, which gets repaid over a fixed period. You must repay the principal (the amount you borrowed), as well as pay interest and other fees.

Depending on the type of loan, lenders issue the money in a lump sum or as a line of credit, which can be spent over time. For example, term loans usually provide funding upfront and in full, whereas a small business line of credit can be spent as needed.

While some small business loans are secured, this is not always the case. In some circumstances, businesses may come across an "unsecured loan."

With a secured loan, you’re required to put up collateral, like real estate or inventory, as a personal guarantee that you’ll repay the loan. An unsecured loan does not require collateral, but these loans typically have higher interest rates.

If you fall behind on the payments or you can’t make the payments, the loan will go into default. At this point, the lender may seize your collateral if you have a secured loan or send the loan to collections. Defaulting on a loan will also cause your business credit score to drop.

There are several types of small business loans available, depending on what you need the money for and how much money you want to borrow.

How long do you have to pay a business loan back?

When you take out a business loan, you’ll pay it back over a fixed period, called the term. Small business loan terms vary in length depending on the lender and the type of loan you get.

For example, the U.S. Small Business Administration’s (SBA) 7(a) guaranteed loan program offers loan terms of up to 25 years for construction and real estate loans. For SBA working capital loans, the maximum loan term is seven years. Most other SBA loans are capped at 10 years.

Long-term small business loans usually have lower monthly payments because you have more time to repay the money you borrowed. However, the caveat is that long-term loans often have higher interest rates compared to short-term loans.

What types of small business loans are most common?

There are several types of small business loans available, depending on what you need the money for and how much money you want to borrow. Here are some of the most common small business loans, and their benefits and drawbacks.

SBA loans

An SBA loan is one of the most common types of small business loans. They’re backed by the U.S. SBA and a portion of the money is guaranteed. If you default on the loan, the SBA will pay back a certain portion of the money. This can make it easier for entrepreneurs to get funding.

The SBA offers several loan programs, including 7(a) loans, 504 loans for purchasing real estate, equipment, inventory, and microloans. You can borrow up to $5 million and pay it off over a period of five to 25 years.

While SBA loans can be easier to qualify for, you must meet a series of eligibility requirements. For example, your business can’t have received money from any other lender, and you must prove that you have invested your own money into the business.

Working capital loans

Working capital loans can provide the cash you need to keep your business operating on a daily basis. This type of loan can be used to run payroll, fund the salaries of new employees, run a marketing and advertising campaign, or pay utility bills for your office.

Working capital loans usually have lower borrowing limits and shorter repayment periods than other business loans. If you want to fund a big purchase, like acquiring another company, this probably isn’t the best loan option.

Equipment and inventory loans

If your business relies on equipment like machinery or electronics, you can take out a loan to help fund the purchase of the equipment your business needs. These loans can also be used to purchase the inventory that your business sells.

Because equipment and inventory loans are typically used to fund a one-time purchase, they usually have short repayment periods. For instance, you might only have a year or two to repay your equipment financing loan, depending on your lender.

Small business lines of credit

A small business line of credit provides access to a line of credit, rather than a lump sum amount of money. It can be a good option if you need to borrow money for your business, but aren’t sure exactly how much you’ll need.

With a small business line of credit, you can spend the money as you need it. You can keep borrowing money, as long as you repay it. However, lines of credit have a draw period, after which time you must pay off any balances, plus the interest on the money you spent.

Term loans

A business term loan is another common type of small business loan. You receive the money up front in a lump sum and pay it back over time, plus interest. Term loans are similar to SBA loans, but they aren’t guaranteed.

Term loans are available from many traditional lenders, online lenders, and banks. Every financial institution has its own eligibility requirements for term loans. For example, you might need to have several years in business and a minimum annual revenue to qualify.

Invoice factoring

If your business collects invoices from clients or customers, you might be able to participate in invoice factoring, which is also called accounts receivable funding. With factoring, you sell your outstanding invoices to a lender and get advanced payment for them.

Invoice financing can help you get access to cash quickly without going through a lengthy loan application process or meeting strict eligibility requirements. However, these loans typically have high fees, so it’s not the best loan option for every small business.

Microloans

Microloans provide a small amount of money for your business. These loans are often used for startup costs or to fund a small project, like a marketing campaign. You can get a microloan from the U.S. SBA, as well as some private financial institutions.

Depending on the lender, microloans may be capped at $50,000. They also tend to have short repayment terms, but lower interest rates. Another thing to know about microloans is that they’re often secured, which means you must put up collateral.

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How do you get a small business loan?

Most small business loans have eligibility requirements. The exact requirements and loan process depend on the type of financing you want and the lender you choose.

When you apply for a small business loan, you’ll need to provide detailed information about your business. The lender uses this information to determine if you’ll be a responsible borrower who’s able to repay the loan at the agreed upon schedule.

Here are some of the qualifications you’re often required to meet to get a small business loan:

  • Business experience: Lenders are more likely to approve your loan application if you’ve been in business for several years. Businesses that have been around for a long time are often viewed as less risky, which can improve your chances of getting a loan. If you’re just getting started, it can be harder to qualify.
  • Annual revenue: Some lenders only issue loans to businesses that have a minimum annual revenue. If you’re starting a business and haven’t turned a profit yet, you might be able to get around this requirement by submitting your business plan, which should include your financial strategy.
  • Cash flow: Assuming your business is already spending money, the lender may require you to submit bank statements and tax returns showing your cash flow. Without any financial statements, it can be difficult to get approved for a small business loan.
  • Credit score: You can expect the lender to check your personal credit score and credit history, as well as your business credit score, if you have one. The better your credit score, the better your chance of getting approved for a loan. Borrowers with good credit may also qualify for a lower interest rate.
  • Debt-to-income ratio: Your business’s debt-to-income ratio (DTI) is the amount of debt you have in comparison to the amount of income you generate. If your business has a lot of unpaid debt, or a high DTI, the lender might be hesitant to give you another loan.
  • Collateral: If you’re applying for a secured business loan, you will need to provide collateral. Common examples of loan collateral include real estate, vehicles, cash, stocks, and business inventory. If you don’t have any business assets, you may be able to use personal assets instead.

Can you get a business loan with no money to start a business?

If you want to start a business, but don’t have any money to invest, it’s still possible to get a business loan. However, you might only qualify for certain types of business loans. For example, most borrowers can get approved for an SBA microloan with no money down.

Other types of loans that don’t usually require a down payment include term loans, equipment loans, business lines of credit, and invoice factoring. However, if you don’t have money for a down payment, it’ll likely impact the loan amount you qualify for.

If you don’t have any money to put down on a business loan, tells the lender you may not have the funds to pay back the loan. As a result, you might only be able to borrow a small amount of money.

Is it hard for a small business to get a loan?

Ultimately, it's up to the lender that would be supplying the loan. The look at several criteria before making a decision, including your credit score, cash flow, the requested loan amount, and current financial obligations. The more you look like you can pay back the loan, the better your chances of getting the business loan. 

There are even loan options for businesses that are just starting up or have bad credit. However, these loans usually come with higher interest rates.

What are the disadvantages of having small business loans?

While small business loans can very helpful in getting a business off the ground, if that business is unsuccessful, it may be difficult to pay them back on a regular basis.

If your business misses a payment or multiple payments, you could risk defaulting on the loan. If you default on a loan, your lender or a collection agency will contact you about the overdue payments and will attempt to collect the money you owe. This may negatively impact your credit score, result in a shutdown of business operations, and make it difficult to secure a future business loan.

Should your business fall on hard times and not be able to make a loan payment on time, it's wise to contact your lender as soon as possible to help discuss other options.

Do you need insurance to get an SBA loan?

Taking out a small business loan is a big responsibility. If you can’t repay your lender, you can face a number of consequences. Defaulting on a loan can incur a bad credit rating and make it harder to get approved for financing in the future.

If you get a business loan, it’s important to protect the money you’ve invested into your business. In fact, lenders often require you to carry certain insurance policies to ensure you repay your loan. Some of these insurance policies include:

An additional policy small business owners might consider is business interruption insurance, which pays for lost revenue and other expenses if your business experiences a covered loss and is forced to shut down temporarily.

For example, if your business inventory gets destroyed in a fire or flood, you might need to spend a significant amount of money to replace everything. Other expenses, like your loan payments, might be difficult to keep up with.

While not required to secure a loan, a business interruption insurance policy could reimburse you for expenses in events like this so that you can continue making your loan payments on time.

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Elizabeth Rivelli, Freelance Writer

Elizabeth is a freelance writer with extensive experience covering commercial insurance and personal insurance lines. Her work has been featured in dozens of online finance publications, including Forbes, Bankrate, and Investopedia. Elizabeth also writes for several insurance carriers.

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