If you’re wondering how business loans work, you are probably in early stages of research to get business financing. You have taken an important initial step: gathering information about what the process is much like and learning what to anticipate if you continue your search for a loan.
However, you might be just a little nervous or unsure about the prospect of getting a company loan because you’re afraid of rejection, of predatory lenders, or of being able to help make the payments. You might also be overwhelmed with the information and never know where to begin. With this particular article, I really hope to provide you with a bit more confidence along with a starting point for the search going forward.
How Small Business Loans Work (The Short Version)
Simply put, a company loan is money you borrow to finance your business. You might obtain your loan from a bank, credit union, or alternative lender online. What sorts of reasons do businesses take out loans? Startup capital, capital for everyday expenses, debt refinancing, expansion, construction, inventory, payroll, you name it—there are loans for every business need. When you get the money, typically as a lump sum payment, you'll then start repaying around the principal, plus interest, usually inside a series of installments.
So why borrow money when you’ll have to repay it, with interest?
Because having access to business capital reveals doors. It'll allow you to keep your business going during tough times, or purchase expansion to grow your company when you’re ready. With the proceeds of a business loan, you are able to fund your payroll expenses throughout a slow season, take advantage of a good deal on bulk inventory, or open a new location for your growing business. If you make all your payments on time, you’ll also develop your business’s credit profile, which supports open up use of more capital in the future.
Types Of Small Business Loans & How They Work
There are lots of various loans plus they all work a little differently.
Different loan products are ideal for different uses. Products with short term lengths, for example short-term loans, invoice financing, and contours of credit, are usually better for capital needs. Long term products, for example medium- or long-term loans, are better for business expansion or refinancing purposes.
Bank, Credit Union, & SBA Loans
- Best for: Long-term investments (expansion, refinancing, construction)
- Not for: Startup capital
Many banks and credit unions offer business loans and lines of credit to eligible merchants. Loans from banks are traditional term loans, also called quick installment loans, that you simply lead to during a period of years (instead of months, as with many online loans). To qualify, you’ll generally need to have good credit and a minimum of 2 yrs in business. Most banks have very long and detailed applications, but they’re worth it to get the lowest rates of interest and longest term lengths.
The Small Business Administration (SBA) is a good resource for merchants who can’t be eligible for a a financial loan by themselves. Rather than issuing loans, the SBA backs a portion of your loan, so your business isn’t as risky, and matches you with one of their partner lenders. To be eligible for a an SBA loan, you’ll still usually need at least 2 yrs running a business, assets you should use as collateral, and fair credit.
Medium-Term Loan
- Best for: Medium- or long-term investments
- Not for: Short-term capital needs
Medium-term loans are quick installment loans that vary from around three to five years in length. These loans are usually provided by online lenders.
Because the word lengths are shorter (and for that reason a lesser risk), medium-term loans are usually simpler to obtain than loans from banks. However, you still have to have an established business (at least annually or two old) to qualify.
Short-Term Loan
- Best for: Short-term working capital
- Not for: Long-term investments
Short-term loans (STL) are online loans with terms which range from three months to two years. Often, these loans carry a one-time flat fee rather than mortgage loan, which means you’ll know the total price of the loan before borrowing. Repayments are made in daily or weekly installments. STLs can be expensive, but they're simple to apply for and could be a life-saver if you want cash immediately—with respect to the lender, you can receive the loan within one business day.
Merchant Cash Advance
- Best for: Emergency cash infusion
- Not for: Long-term investments
Technically, merchant cash advances (MCA) are not loans—they’re sales of future receivables. These “purchases” are collected by deducting some of the sales every day. Even though they don't have any set term lengths, most MCAs are structured to be paid back over the course of three months to 2 years. MCA borrowing rates are usually even higher than those for STLs, though they're extremely fast and simple to be eligible for a.
Lines of Credit
- Best for: Small, frequent cash infusions
- Not for: Large, one-time investments
Lines of credit (LOC) function similarly to credit cards—you're given access to some money, you are able to draft for your limit without notice, and also you only have to pay interest around the amount you’ve borrowed. This kind of financing is excellent for businesses that frequently have to borrow small amounts of capital.
Many LOCs are revolving, which means your lines are replenished while you repay funds you’ve borrowed.
Lines of credit can be found by many lenders—both online and through banks. Term length for LOCs varies, but generally online lenders offer shorter-term lines of credit, whereas banks offer longer terms on their own LOCs.
Personal Loan For Business
- Best for: Startup capital
- Not for: Large investments
Merchants within the earliest stage of starting a business often don’t have access to a whole lot of capital. If you’re not able to continue bootstrapping and/or have exhausted the bank of family-and-friends, you could look at getting a personal bank loan for business.
Because unsecured loans are based on your own personal creditworthiness, not that of the business, these financing options are attainable, even though you don’t yet have sufficient profits or amount of time in business. Remember that these are typically small loans, typically maxing out at $35-$50K.
Equipment Financing
- Best for: Purchasing or leasing business equipment
- Not for: Anything else
Equipment financing is exactly what it may sound like: a loan to finance business equipment. Your lender fronts the money to buy the equipment, and you repay it in installments until you own the equipment outright. This type of loan typically doesn’t require any business collateral or even good credit, because the equipment itself can serve as the collateral.
Equipment leasing is really a subcategory of apparatus financing, where you pay to make use of the gear, but aren't purchasing to possess (kind of like leasing a car).
Invoice Financing
- Best for: Turning unpaid invoices into immediate cash
- Not for: Companies that are able to afford to wait for customers to pay for their invoices in full
Invoice financing is a kind of business financing open to businesses (usually B2B businesses) that frequently have a lot of money tied up in unpaid invoices. With invoice financing, a lender will extend a credit line based on the value of your unpaid invoices, and you repay your LOC while you collect in your invoices. Because of the often high fees involved, you need to generally only choose this option if unpaid invoices represent huge burden to your business, and you need immediate cash.
Invoice factoring is comparable, but slightly different. With this type of financing, you really sell your invoices to a factoring company, at a pretty steep discount. After that it becomes the factor’s responsibility to collect on these invoices. Find out more about the differences between invoice financing and factoring invoices.
What To Expect From The applying Process
Every lender’s application is a little bit different, but most stick to the same three stages: prequalification, verification and underwriting, and funding.
Prequalification
In the prequalification stage, you will have to complete detailed information about you, your business, your business’s finances, and just what you’re searching for in a loan. The information at this time is generally unverified, though obviously, you should still be as accurate as you possibly can.
Some lenders will even allow you to complete this stage informally over the phone or online.
An underwriter, or, often, a pc, will appear at the application and determine if you’re qualified to receive funding.
If so, at this time many lenders will present approximately loan offer to you. This offer will detail details about your potential loan, as well as your borrowing amount, interest rate, fees, term length, and size of periodic repayments. Ideally, the quote will also include information to help you compare loan offers, including the APR and/or the cents around the dollar cost.
If you’re still deciding from a few lenders, have an estimated loan offer from each one to easily compare your choices.
Contrary to what lots of people think, being “prequalified” for any business loan does not necessarily mean that you're necessarily approved for funding. To be officially approved, you need to complete the next step.
Verification & Underwriting
Before actually providing you with money, lenders will have to verify your information. This task primarily involves supplying documentation with regards to you as well as your business, so lenders can be sure they’ve offered a deal that will fit your business (and that you’re not lying to them).
During this stage, lenders may request financial documentation. Your lender might request documents like these:
- Proof of identity
- Recent business bank statements
- Recent business charge card statements
- Business tax return
- Personal tax return
- Profit and loss statement
- Balance sheet
- Debt schedule
- A/R aging
The faster you can hand over the documents requested from your lender, the faster the application process will go, and also the faster you’ll have the ability to access your borrowed funds.
Many lenders also need you to complete steps to ensure your identity, which might include answering basic personal questions over the phone or having a code mailed to your residence.
At no more this method, you'll be given a final offer. In some cases, this offer might be different from the quote you received throughout the prequalification stage, so it’s important to go over all of the information to guarantee the offer is something want. As always, prior to signing an agreement, read the small print.
Funding
At this point, the only thing left to complete is to buy funded!
After you’ve accepted an offer, the lender will send the cash to your bank account. Normally this happens via an ACH transfer, meaning the cash will take one to two working days to transfer between banks.
How Lenders Assess Your Eligibility For A Small company Loan
When evaluating a company loan application, lenders look at various information to find out whether it’s smart to give loan to you. In addition to taking a look at your time running a business, credit score, and revenue, lenders also consider how you compare from the 5 C’of credit and data points like DSCR and DTI.
5 C’s Of Credit
Lenders think about the following traits, also referred to as the “5 C’of Credit,” when considering whether to lend to a business:
- Character – The borrower’s reputation and perceived trustworthiness.
- Capacity – The borrower’s ability to repay the borrowed funds.
- Capital – How much cash the borrower has put toward the investment.
- Collateral – What assets the borrower provides as insurance in case of a default.
- Conditions – The circumstances from the loan the borrower needs, along with the current state of the economy generally.
While they are somewhat general traits, they paint a great overall picture of how likely your business is to settle the loan on time.
Personal Credit Score
Your personal credit rating is really a way of measuring how good you’ve repaid the money you owe previously. Lenders want to be sure that you, the company owner, possess a history of repaying debts on time. In the end, for those who have past responsibly repaying debts, you’ll likely continue to do so in the future.
Time In Business
The longer your business has survived, the much more likely it's to do this in the future. Before granting your company capital, lenders want to be sure that your company has withstood the exam of time.
Loans with longer term length often need a longer time running a business.
Business Revenue
Quite simply, your company needs to be making enough money to settle the debt. The quantity of revenue you’re currently making determines the maximum loan size you'll be eligible for—often lenders won’t allow you to borrow more than 10% – 15% of your annual revenue.
Debt Service Coverage Ratio & Debt-To-Income Ratio
Your debt service coverage ratio (DSCR) basically tells your lender (and yourself) how much money available for you to settle additional debt or make periodic loan payments. Your DSCR is calculated using this equation:
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Net Operating Income / Total Debt Service = DSCR
A DSCR higher than one means that you're making enough money to pay for your present debts, and you could manage more debt without a problem. Usually, lenders like to see that you've a DSCR of 1.15 or over.
A similar data point lenders consider is the debt-to-income ratio (DTI), which is expressed like a percentage. This is actually the DTI ratio formula:
Total Monthly Debt / Gross Monthly Income = Debt-To-Income Ratio
Acceptable DTIs vary by lender, but generally, a DTI of 36% or lower is considered good. However, some lenders will be able to finance you for those who have a DTI as high as 43%.
How Small Business Loan Repayment Works
Loan repayment is usually pretty straightforward, but methods can vary somewhat from lender to lender. The length of a loan’s term will obviously change from one loan to the next—and it'll obviously create a huge difference whether you have to repay the loan within three months or 5 years. Other than that, the primary differences between loans, when it comes to repayment, are if the loan repayments are fixed or variable, and how often you have to make payments (payment frequency). You may also have some flexibility in the way you repay (payment method), but generally, loan repayments are automatically deducted out of your bank account.
Fixed vs. Variable Repayments
Borrowers with a fixed repayment pay the same amount every time they make a payment. For example, a borrower might have to pay $341 on the bi-weekly basis before the loan is paid off. Barring extraneous circumstances, the borrower will never pay more or less compared to $341.
Variable repayment means that the amount you’re paying may change. You may have a variable repayment schedule for 1 of 2 reasons:
You possess a loan (or advance) that is repaid by deducting a portion of the income. For instance, your lender might deduct 15% of each sale before the debt is repaid. These financing options don't have a maturity date, because repayment depends upon your cash flow.- Your rate of interest depends upon the prime rate. If the prime rate goes up, so will your interest rate and therefore your payments. Naturally, if the rate of interest drops, your interest rate and payments will as well. The prime rate is generally utilized by lenders who offer loans with long-term lengths, or the ones that offer lines of credit.
Repayment Frequency
In the past, just about all loans were paid monthly. Nowadays, lenders may require payments in many different intervals, including monthly, bi-monthly, weekly, or daily. Daily repayments are usually only made every weekday, excluding bank holidays.
Repayment Method
Gone is the time if you need to make sure to write and mail inside a check (mostly). Now, most lenders go for an automatic repayment system, in which your payments are deducted right out of the banking account via ACH. All you have to do is ensure the cash is within the proper bank account.
Some still allow payment via checks. However, many charge a cheque processing fee, which could cost your company a significant cost of money over time.
Final Ideas on How Loans Work
Business loans are fantastic tools to increase your liquidity so that your business can thrive in happy times and bad. However, it’s vital that you know how loans work in general, along with the terms and conditions associated with a particular loan you're trying to get.
Reputable online lenders are as transparent as you possibly can, both on their websites and in their communications with applicants. Predatory lenders, however, tend to hide behind too-good-to-be-true advertising, while offering few (if any) specific information regarding their financial products. Before signing on for a financial loan, be sure you understand how much your payments will be, how frequent they will be, and just how much you'll pay for that loan in total. Use our small business loan calculators to assist figure out these important details.
And finally, here are some more educational resources we think you will probably find helpful in your research about small business loans:
- First Time Business Loans: Learn Where & How To Apply
- Types Of Small company Loans: 12 Types You need to Know
- Online Business Loans: What They Are & When you should Get One
- Short-Term Small Business Loans: The Complete Guide
- What Business Quick installment loans Are & How They Work
- Guide For you to get A Business Line Of Credit For Small Businesses
- Invoice Financing: The entire Guide For Businesses
- What Is Equipment Financing?
Still have questions? Leave them within the comments and I’ll respond to them for you personally.
