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How Do Small Business Loans Work?


How Do Small Business Loans Work

Are you ready to start a new business or to grow an existing one? Being an entrepreneur may be expensive, and you might find that you need to take out a loan to fund your small business. A business loan, much like any other loan, is money borrowed from a lender that has to be paid back, along with interest and other costs, over the course of a predetermined amount of time.


There are a wide variety of different types of loans available for small businesses, and every lender has their own criteria for eligibility. Learn more about the steps involved in getting a loan, and then choose the method of financing that meets your requirements the best.


What Is a Small Business Loan?

The term small business loans refers to a wide variety of funding solutions that can be acquired from a variety of lenders and used by businesses for a variety of purposes. These loans have developed over time to meet the requirements of business owners who are working toward accomplishing their objectives. As a direct consequence of this, the operational specifics of a loan for a small business can differ significantly depending on the kind of loan being applied for.


A small business loan are a form of commercial funding that is made available to businesses that meet the requirements by various financial institutions, including traditional banks, online lenders, and credit unions. Businesses have the opportunity to make use of these funds in order to handle the costs that are associated with running and expanding their operations. These costs include a wide variety of requirements, such as working capital and the purchase of new equipment, as well as more substantial investments, such as purchasing real estate.



How Small Business Loans Work

When you secure a loan for your small business, you are borrowing money with the intention of growing or expanding your business. In most cases, the repayment of small business loans are spread out over a predetermined amount of time and is subject to interest and fees. There is the option of either securing or not securing the loan. When you take out a secured loan, you are required to put up collateral, which is an asset that the lender can take possession of if you do not pay back the loan. The money, the equipment, or the real estate could serve as the collateral. Unsecured loans regularly require the backing of a personal guarantee, in which the borrower and the other business owners cosign the loan and agree to be personally responsible for its repayment.


What Are Business Loans Used For?

There is a wide variety of ways that business loans can be put to use. However, when you ask for financing, you will typically be required to explain to the lender how you intend to put the capital to use in the future. A few examples of common uses are:

  • Startup costs

  • Investing in commercial property through the purchase and/or renovation

  • Cashflow for day-to-day expenses

  • Consolidation of debt or refinancing

  • Equipment purchases

  • Purchases made for inventory

  • Business acquisitions

  • Business expansion

  • Business franchising

  • Marketing and advertising

  • Refinancing

You may have noticed that the list above is lacking an important category of acquisitions, namely personal expenditures. In general, lenders will not permit you to use business loans to cover private expenses such as the acquisition of a residential property, personal automobiles, or other activities that are not directly tied to a requirement for your business.


Common Types of Small Business Loans

There are a wide range of financing options available to small businesses today from a variety of institutions, including online lenders, large banks, credit unions, and firms like Steer Financial that facilitate small business financing. The following popular types of business loans come with a variety of loan amounts, interest rates, fee structures, eligibility requirements, potential applications, and terms of payback.


Business Lines of Credit

Business owners that use business lines of credit can borrow as much or as little as they need, as long as they stay within their credit limit, giving them flexibility. There are both secured and unsecured credit lines.


Merchant Cash Advance

When a business needs capital quickly, a merchant cash advance (MCA) may be a simple method to get access to short-term funding. In exchange for a one-time payment of cash, business owners provide the lender—often a merchant services firm—a percentage of future sales receipts. This sum plus fees is reimbursed daily or once a week by automatic clearing house (ACH) payments or from the company's individual sales.


The faster loan application procedure and less strict qualification standards, tend to be a bit of a higher cost. MCAs could be an excellent choice for businesses with strong sales volumes that need quick access to capital but don't meet the requirements for a conventional business loan.


Equipment Financing

Your business may benefit from equipment financing to cover costs such as equipment, including large manufacturing gear or small pieces of equipment. The cost of the equipment being financed determines how much the loan will be. Lenders frequently request a down payment of roughly 15% even though they normally finance between 80% and 100% of the equipment prices. The terms range from three to ten years.


SBA Loans

The U.S. Small Business Administration, a federal organization that aids entrepreneurs in expanding their enterprises, guarantees SBA loans for small businesses. A guarantee states that the SBA will pay you the guaranteed sum if you are unable to make your payments to your lender.


The SBA backs 85% of loans under $150,000 and 75% of loans over that amount. SBA small business loans might be challenging to obtain due to its guarantee.


Invoice Factoring

Businesses that send invoices to other businesses using an invoicing system may be qualified for invoice factoring. This kind of business finance is selling your business's unpaid invoices to a factoring company. The factoring company will then advance you a percentage of the unpaid invoices (typically 70% to 95%) and take over collection responsibilities. The factoring company pays your business the leftover balance after collection, less the factoring fees. For each month that an invoice is delinquent, factor costs normally range from 0.50% to 5%. For newer businesses and startups with weak credit histories, invoice factoring is a useful financing option.


How to Qualify for a Small Business Loan

The lender, loan type, and loan amount will all affect whether you qualify for a loan, however there are basic requirements that apply to most small business loans:


Personal and Business Credit Scores

Your personal credit score will be considered by lenders who provide small business loans in order to decide whether or not to lend you money. Your personal credit demonstrates your capacity to pay back personal debts like credit card balances, mortgage loans, and auto loans. The higher it is, the less risky you appear to a lender, and the more probable it is that your loan application will be accepted.


What then qualifies as a good credit score? A score of 800 or higher is regarded as exceptional, while a score of 700 or higher is regarded as good. Visit AnnualCreditReport.com to get free copies of your Experian, TransUnion, and Equifax credit reports and learn your credit score. Additionally, Experian offers free credit reports every 30 days.


Pay your bills on time, pay off debt, and keep the balances on your credit cards and other revolving credit low if your credit score is lower than you'd like it to be. Avoid asking for credit too frequently because doing so can result in numerous hard inquiries in your credit file and harm your score.


Your business credit score is usually established once your business is open. Open business accounts in your business’s name, incorporate or create an LLC, get an Employer Identification Number (EIN), and you can start building business credit.


Understand the Lender's Requirements

You can improve your chances of getting a small business loan accepted by being aware of a lender's minimum standards and qualifications. While some lenders might be flexible, the majority of them have minimum requirements for creditworthiness, annual income, and years in business. Bank loans and loans supported by the SBA are the two kinds of business loans that are the most challenging to be approved for. Although 640 is often the lowest credit score required for these loans, higher scores in the 700s or 800s are desired.


The conditions are less strict for small company loans from peer-to-peer lending websites and direct online lenders. With a credit score in the low to mid 600s, which is typical or above average, you might get accepted. You will need a number of legal and financial documents to complete the application form, in addition to meeting the credit score standards. Your driver's license, a voided business check, bank statements, profit and loss statements, personal and business tax returns, and a business plan are likely to be among the items on this list.


Provide Collateral

To obtain a small business loan from some lenders, you may need to pledge security or an asset like real estate, machinery, or stock. By offering collateral, you grant lenders the right to take it and sell it in the event that your firm faces financial difficulty and you are unable to make your payments.


For instance, you need to provide collateral and a personal guarantee of at least 20% of the business from each owner if you want to obtain an SBA-backed loan. Your possessions and credit report are at danger due to this personal guarantee. Unsecured business loans, which do not require collateral and may have less advantageous conditions, may make more sense if you are concerned about losing an asset or do not have one.


Before applying to a particular lender, research it to see whether your business will likely meet the requirements.


FAQs About Small Business Loans

How Much Would I Qualify for a Small Business Loan?

Do Small Business Loans Have to Be Paid Back?

Can I Get a Small Business Loan With a Low Credit Score?


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