How Do Small Business Loans Work?

Quick Answer

Small business loans provide a lump sum of money or a flexible line of credit you can use for business operations, startup or growth. Banks, credit unions and online lenders offer a wide variety of business loans, so it’s important to choose the right loan for your needs.

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Whether you're preparing to start or expand a business or seeking to survive a sales slump, a business loan can offer the financial boost you need to succeed. Small business loans can provide a lump-sum payment or a flexible line of credit you can tap for business purposes.

But with so many business loan options available, choosing the loan that best fits your needs—and your business—is key to getting your loan approved. Here's how small business loans work, how to get one and other financing options to consider if a loan isn't right for you.

How Do Small Business Loans Work?

Small business loans are designed to help entrepreneurs start, expand or operate their businesses. For example, you might use a business loan to cover operating expenses such as buying inventory, hiring more employees so you can expand, purchasing new equipment or buying a building for your business.

You can get small business loans from banks, credit unions, online lenders or community nonprofit organizations. You'll receive a lump sum or line of credit and pay it back over a specified loan term with interest. Loan terms and interest rates vary depending on the lender, the loan type and amount, and the borrower's credit scores.

Lenders generally prefer making loans to established businesses with a track record of profitability. Getting a loan for a startup business can be more difficult and may require pulling together smaller loans from several sources.

In any stage of business, lenders typically evaluate factors including your credit score, your business experience and your business income when considering your loan application.

Types of Small Business Loans

There are several types of small business loans to choose from.

Bank Term Loans

Term loans from banks provide a lump sum that you repay over a set time in fixed monthly installments. Short-term loans are generally repaid in six to 24 months; long-term loans typically have repayment periods of three years or more. Bank loans secured by collateral generally offer lower interest rates than unsecured loans; however, the lender can take your collateral if you fail to pay back the loan.

SBA Guaranteed Loans

The U.S. Small Business Administration (SBA) is a federal agency that guarantees a portion of loans made by its partner lenders, reducing lenders' risk. SBA 7(a) loans, available for up to $5 million, may have fixed or variable interest rates and can be used for a variety of purposes, including working capital or refinancing debt. SBA 504 loans, available for up to $5.5 million, have fixed interest rates and can be used to purchase long-term, fixed assets such as real estate or machinery.

SBA Microloans

The SBA's microloan program guarantees small loans of up to $50,000 through nonprofit partner organizations. Funds can be used for business startup or expansion; terms vary by lender. Microlenders often provide management or technical assistance to help borrowers succeed.

Other Microloans

In addition to SBA partners, many community-based or nonprofit organizations offer microloans. These microlenders often target borrowers who traditionally lack access to capital, such as women, people of color or low-income individuals. Well-known small business microlenders include Accion Opportunity Fund, Kiva and Grameen America.

Business Lines of Credit

Unlike loans that pay out a lump sum, business lines of credit offer a flexible financing option for short-term needs. A business line of credit works similarly to a credit card, but typically offers a higher credit limit. You can borrow money up to your credit limit during the "draw period," and pay interest only on what you borrow. As you repay funds, they become available to borrow again until your draw period ends.

How to Get a Small Business Loan

Small business loans are available from banks, credit unions, direct online lenders and microlenders. When seeking a small business loan, follow these steps to boost your odds of success.

  1. Check your personal and business credit scores. Lenders typically evaluate both scores when considering your loan application. Higher credit scores may qualify you for larger loans and more favorable loan terms. Knowing your credit score also helps you identify lenders whose criteria you can meet. You can improve your credit scores by paying down debt, paying bills on time and avoiding unnecessary new applications for credit.
  2. Know how much money you need. Determine what you'll use the loan for, how much you'll need and how long it will take to repay the loan. This information helps you find the right loan size, type and term for your needs.
  3. Gather required information. Depending on the lender, you may need to provide business and personal tax returns, business bank statements, balance sheets, business formation documents and business licenses. Some lenders require a business plan too.
  4. Check your eligibility. While there may be some flexibility, lenders generally have minimum requirements for credit scores, time in business and annual revenue. Some loans also require collateral, such as real estate, inventory or equipment, to secure your loan.
  5. Compare loan offers. Many lenders let you submit information to prequalify for business loans and get estimated loan amounts and terms. You'll then complete an application to receive your final loan offer. When comparing loans, consider the annual percentage rate (APR), loan amount, repayment term, fees, penalties, monthly payment and how quickly you'll receive the money.

Alternatives to Small Business Loans

A small business loan isn't your only financing option. Here are some alternatives:

  • Business credit card: This could be all you need to finance smaller expenses. Making timely business credit card payments and minimizing credit utilization can help build a business credit history. Some business credit cards also offer rewards or useful financial management features. Business credit cards are exempt from the Credit CARD Act of 2009, but if you pay your balance in full each month, you'll avoid costly interest.
  • Crowdfunding: This peer-to-peer financing option raises money from individuals. Popular business crowdfunding platforms include Fundable, Indiegogo and WeFunder. Some crowdfunding sites aggregate money from individual investors to issue loans you must repay; others let you solicit donations from individuals in return for rewards such as early access to your product or service.
  • Personal loans: These are widely available in amounts ranging from a few hundred dollars to $200,000 and usually don't require collateral. Some lenders forbid borrowers from using personal loans for business; check with lenders before you apply. Unlike business loans, paying back a personal loan won't help build a business credit history. Since failing to repay the loan could significantly damage your personal credit score, make sure you can handle the payments before applying for a personal loan.
  • Friends and family: Asking your support network to help is a common source of financing, especially for startups. Some 83% of small businesses with employees used funds from personal savings, friends or family within the past five years, Federal Reserve data shows. Treat a loan from loved ones as you would a bank loan: Create a loan agreement and repay the loan with interest.
  • Accounts receivable factoring: Also known as invoice factoring, this is an option for established businesses that invoice clients. You sell unpaid invoices to a factoring company and receive a percentage of the invoice's value upfront. The factor pays you the rest of the invoice (minus fees and interest) after they collect payment from the client. Factoring requires no credit check, making it a useful option when you need money fast.
  • Merchant cash advance: Businesses that accept credit and debit cards can get an advance on future payment card sales from merchant cash advance (MCA) providers. Your revenues are more important than your credit score in obtaining an MCA. However, MCAs usually involve high interest rates and daily or weekly payments, which can make this a less-than-ideal option.

Frequently Asked Questions

  • How easy it is to get a business loan depends on factors including your time in business, revenues, business plan and how much you want to borrow. You're more likely to get a business loan if you have an established business, positive cash flow and good business and personal credit scores.

    The good news: 79% of small business owners who applied for financing in 2022 received at least some of the money they needed, according to the Federal Reserve. To improve your chances of getting a small business loan, choose a lender whose criteria you can meet. Loans from online lenders are typically easier to get than SBA loans or bank loans, for example. Improving your credit score before applying and putting up collateral may also help you get a business loan.

  • The minimum credit score needed for a small business loan varies. In general, bank and SBA loans require a personal FICO® Score of 640 or higher; a score in the 700s or above is preferred. Online lenders usually have lower credit score requirements, with some as low as 500.

    Your credit score isn't the only factor in getting a small business loan. Having stable revenues, an established business and collateral to offer can help offset a lower credit score. However, business loans available to those with lower credit scores generally charge higher APRs, increasing the cost of borrowing.

  • SBA microloans for startup businesses are limited to $50,000; the average SBA microloan is about $13,000. After a year or two in business, you may qualify for online small business loans, which can range from a few hundred dollars to $250,000. SBA 7(a) loans go up to $5 million, but these larger loans are generally reserved for established businesses. With any type of loan, the amount you can borrow depends on factors including your credit scores, business income and ability to repay the loan.

The Bottom Line

Getting your business and personal credit in top shape can smooth your path to business borrowing. Check your business credit report and credit score, as well as your personal credit report and credit score, and resolve any issues before applying for a loan. Making payments on time and reducing debt can help improve your credit scores, which may make it easier to get the small business loan you seek. If your lender reports your account to the major business credit bureaus, making timely business loan payments will help build your business credit score, unlocking new opportunities for financing as your business grows.