How Do Small Business Loans Work?

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Whether you've developed a product, thought of a unique solution to a common problem, or simply love the idea of being your own boss, there are plenty of reasons you may want to own a small business.

If you choose to pursue business ownership, you'll quickly learn that it takes quite a bit of money, especially upfront, to get it up and running. A small business loan can provide you with the cash your venture needs to succeed.

What Is a Small Business Loan?

Small business loans are types of financing provided to companies for different purposes by various lenders. Over time, several types of small business loans have evolved to help entrepreneurs meet their goals. Therefore, the way a small business loan works depends on the type of loan in question.

Types of Small Business Loans

There are a variety of small business loans you can consider:

Small Business Line of Credit

A small business line of credit is similar to a credit card. You can borrow up to a certain limit and only pay interest on the amount of money you borrow. If you take out a small business line of credit, you'll be able to draw funds and repay them as often as you'd like as long as you don't go over your credit limit.

Accounts Receivable Financing

Also known as factoring, accounts receivable financing involves selling your receivables or outstanding invoices to a lender so you can receive early payment for them. The lender takes the risk on your receivables and provides your business with some cash in exchange for a fee. Age and quality of the receivables will play a role in the amount of money you'll receive. While quick access to cash is an advantage of accounts receivable financing, you're likely to pay more for this type of financing than others, especially if your business credit is less than stellar.

Working Capital Loans

Unlike some small business loans intended to pay for long-term assets or investments, working capital loans are used to finance the everyday operations of your business. These operations can include things like rent, payroll and debt payments. Compared with other small business loans, working capital loans feature shorter terms and lower amounts. These loans are sometimes linked to your personal credit, which could take a hit if you don't make your payments on time.

Small Business Term Loans

If you take out a small business term loan, you'll get a lump sum of capital that you'll pay back at a fixed interest rate with regular repayment terms. In most cases, these types of loans are repaid in five years and used to fund a specific investment for a small business.

Just like mortgages and car loans, small business term loans usually follow an amortization schedule, meaning most of your payment will go toward your interest at the beginning.

SBA Small Business Loans

SBA loans are small business loans guaranteed by the U.S. Small Business Administration, a federal agency that helps entrepreneurs grow their businesses. A guarantee means that if you aren't able to make your payments to your lender, the SBA will pay out the guaranteed amount.

The SBA guarantees 85% of loans that are $150,000 or less and 75% of larger loans. Due to their guarantee, SBA small business loans can be tough to get.

Equipment Loans

Equipment loans can help your small business replace existing equipment or buy new equipment as it grows. If you're a health care business, for example, you may use an equipment loan to pay for things like X-ray machines or infusion pumps. Typically, equipment loans require less documentation than other small business loans, so you can receive funding fairly quickly.

Small Business Credit Cards

While a small business credit card is similar to a personal credit card, there are a few noteworthy differences. A small business card may provide you with reporting features so you can categorize and track your spending. It may also feature a rewards program that can help you save on common business expenses like office supplies and marketing services. Additionally, it is exempt from the Credit CARD Act of 2009.

Where to Get a Small Business Loan

There are several different places you can go to for a small business loan, including:

Direct Online Lenders

There are many online lenders that offer loans directly to small business owners. Since they use the power of technology and algorithms, their loans are quicker to obtain than the loans of traditional lenders like banks.

However, the costs of borrowing with direct online lenders is typically higher. You may want to pursue this route if you need access to quick cash and are having trouble qualifying for a loan from a traditional lender.

Large Commercial Banks

While large commercial banks have rigorous requirements for small business loan borrowers, they have the power to offer larger loans than other lenders, which can be very helpful when you're growing your business.

Another advantage of taking out a small business loan from a large commercial bank is the chance to lock in low interest rates. Keep in mind that while financing with a commercial bank has its pros, these loans can be challenging to qualify for, especially if you don't have the best credit.

Large Community Banks

Community banks are locally owned and operated. Because they are typically smaller than commercial banks, they can provide you with more individualized service, which can be a huge plus as your business grows.

In addition, unlike commercial banks, which may solely focus on your credit score and financial statements, community banks are more likely to look at your entire credit report and other aspects of your business. This is a huge advantage if you have a solid credit history but don't have the best credit score.

Peer-to-Peer Lending Sites

Small business loans from peer-to-peer lending sites such as Prosper and Lending Club are often easier to qualify for than loans from traditional lenders because the money comes from a group of investors instead of a single lender. These types of loans usually come with higher interest rates that can increase the overall cost of your loan.

Here's how peer-to-peer lending sites work: The P2P lending site acts as the middleman between you (the borrower) and the investors. It can match your loan request with investors' funds. Investors that lend to you will receive the interest you pay on the loan minus the lending site's fee.

Bank Lenders Backed by the SBA

Many SBA preferred lenders are banks that have strict requirements for applicants.

Although SBA loans are difficult to qualify for, they are definitely worth considering, as they come with lower down payment requirements, lower interest rates and longer repayment terms than other options.

How to Qualify for a Small Business Loan

The process of qualifying for a small business loan involves several steps that we'll outline below.

Build Your Personal and Business Credit Scores

Lenders that offer small business loans will take a look at your personal credit score to help them determine whether they should lend you money. Your personal credit shows your ability to repay your personal debts like your mortgage, car loans and credit cards. The higher it is, the less risky you are in a lender's eyes and more likely you are to get approved for a loan.

So, what constitutes a good credit score? While a score of 700 or above is considered good, a score of 800 or above is known as excellent. To find out where your credit score stands, visit and obtain free copies of your reports from Experian, TransUnion and Equifax. You can also get a free credit report from Experian every 30 days.

If your credit score is lower than you'd like it to be, pay your bills on time, pay off debt and keep balances low on credit cards and other revolving credit. Also, refrain from applying for too much credit, as doing so can create multiple hard inquiries in your credit file and have a negative impact on your score.

Once you've built your personal credit, it'll be time to focus on your business credit score. To begin establishing business credit, incorporate or form an LLC, obtain a federal Employer Identification Number (EIN), and open business accounts in your business name.

Know the Requirements

By understanding a lender's minimum requirements and qualifications, you can increase your chances of getting approved for a small business loan. While some lenders may be flexible, most of them require that borrowers meet a minimum credit score, annual revenue and years in business.

Out of all the types of business loans available, loans from banks and those that are backed by the SBA are the most difficult to qualify for. While the minimum credit score for these types of loans is typically 640, a higher score in the 700s or 800s is preferred.

When it comes to small business loans from direct online lenders and peer-to-peer lending sites, requirements are less stringent. You may be able to get approved with an average or above average credit score in the low to mid 600s.

In addition to meeting credit score requirements, you'll need various legal and financial documents to complete the application paperwork. These documents will likely include things like your driver's license, a voided business check, bank statements, profit and loss statements, business and personal tax returns, and a business plan.

Develop a Business Plan

The purpose of a business plan is to show lenders how you plan to use your money. Your business plan will help convey the purpose of your loan and how you believe it will help you become more profitable. When creating your business plan, make sure to include the following information:

  • Business description
  • Product or service description
  • Market analysis
  • Management team
  • Sales and marketing strategy and implementation
  • Financial plan and projections

Provide Collateral If Required

Some lenders require you to provide collateral or an asset like real estate, equipment or inventory to take out a small business loan. When you provide collateral, you give lenders the right to seize and sell it if your business struggles and you are unable to make your payments.

To take out an SBA-backed loan, for example, you must offer collateral in addition to a personal guarantee (from each owner, if there's more than one) of at least 20% of the business. This personal guarantee puts your assets and credit score at risk.

If you're worried about losing an asset or don't have one, an unsecured business loan, which does not require collateral, may make more sense—even though it may come with less favorable terms.

Know Your Options

Getting approved for a small business loan is a lot easier when you've done your research and know all of the options available to you. Regardless of what type of loan you receive, make it a priority to pay it back on time so that it helps rather than hurts your venture.