How Do Small Business Loans Work

Share
Share
Share
Email

Small business loans offer several benefits when compared to other forms of financing. Unlike investor funding or selling company shares, you don’t give away a portion of your business equity with a loan. Compared to crowdfunding, small business loans are far more reliable and faster in acquiring the funds you need for your company.

Here, we look at how small business loans work and the various available options.

Understanding Small Business Loans in Five Easy Steps

How do small business loans work?

To answer that question, you need to understand the process of applying for these types of loans.

1. Apply for Business Loans

Some traditional lenders require you to apply for a loan in person at a bank branch. Others may allow you to apply online as long as you can supply the necessary documentation.

2. Lender’s Check for Business Loan Qualification

Upon receiving your application, the lender reviews it against their approval criteria for the small business loan. These checks typically include examining the following factors of your business:

Be a for-profit business

Many lenders only grant small business loans to for-profit companies. If you operate a non-profit model, you may have a better chance of receiving funding from a national or state grant program.

Location & Years in Business

Many U.S.-based lending contracts have clauses stating that your business must be in the United States. Lenders typically check how long you’ve been in business, too. The older your company is, the less risk it poses to a lender.

Usage of Loan

Different loan types have different usage terms, so how you use the loan depends on the type of loan you receive. For example, a working capital loan provides funds to help you deal with daily expenses, meaning you can’t use it to invest in new assets.

Good Credit Score and Credit History

Your personal and company credit scores indicate whether you’re a reliable borrower. Poorer scores represent more risk, making the application less likely to succeed. The stronger your credit history and score, the more likely you are to get the money you require.

Low Risk Profile

Beyond checking credit scores, lenders also consider your company’s overall risk profile. Does it have any existing debts? Is it subject to any defaults? What is the company’s annual revenue? These are the types of questions a lender considers during the application process.

Tax and Other Financial Documents

Think of your company’s financial documents as a paper trail of evidence that demonstrates its authenticity. Lenders look at your tax returns, business registration, and similar financial records to ensure there’s no evidence of misdoings.

3. Finalizing Loan Amounts, Interest Rates & Other Terms

After completing their check, a lender then considers whether your company can repay the amount of money you want. The lender determines an appropriate loan amount and the interest they will apply, along with whether they require collateral.

Different types of small business loans come with varying terms. For example, many big banks and government-based loan schemes only allocate up to 90% of the loan amount you request. However, applying with an alternative lender increases your chances of getting your desired amount.

4. Disbursal of Loan Amount

The type of business loan impacts how the lender disburses the money. Many online lenders send the money within 24 hours of approving a small business loan. Larger banks and financial institutions may take longer or may parcel out the disbursement into smaller chunks.

Repayment Process

Most loan contracts agree upon a weekly or monthly repayment, with interest, based on the loan’s terms. Failing to make repayments could lead to legal action from your lender. You may also lose any collateral attached to the loan.

How Do Different Types of Business Loans Work?

The specific terms and conditions of the loan vary depending on your loan type.

Small Business Line of Credit  

A small business line of credit involves a lender giving you access to funds up to a credit limit. You only pay interest on the money you draw, making this one of the more flexible types of small business loans.

This type of loan works best for seasonal companies and those with short-term financing needs. For example, your business may have an unexpected cash flow issue due to a client failing to pay their invoice. You can use a line of credit to cover payroll until you receive what you’re owed from your client.

Accounts Receivable Financing

Accounts receivable financing involves showing your purchase orders or receivables to a financial institution, which usually provides up to 80% of the value of those assets. You receive the money in a matter of days, with loan terms tending to last for one year.

This loan type is ideal for companies that have unpaid invoices. It allows you to access most of the balance of those invoices early. You can then repay the loan, plus any interest applied, once you receive the payment from your clients.

Working Capital Loans

Working capital loans allow you to fund everyday business expenses. These expenses include:

  • Rent
  • Payroll
  • Operational costs
  • Bills
  • Emergency expenses

You can also use a working capital loan to cover temporary cash flow gaps.

These are temporary loans best used by businesses that have short-term cash flow issues. You can use a working capital loan to stay operational while making repayments over several months. For example, a seasonal business may use this type of loan to stay solvent during its off-season periods.

Small Business Short Term Loans

Short-term loans come with several advantages, such as access to funds within 24 hours. They’re perfect for when you need fast access to up to $500,000, with repayment terms tending to fall between one and three years. These types of business loans also have less stringent eligibility criteria.

Short-term loans are great for giving your company a quick cash injection when it’s needed. For example, a startup could use this type of loan to hire new people who will help the company grow.

Merchant Cash Advance

You receive a lump sum payment with this type of loan. However, you don’t make monthly repayments. Instead, your lender takes a percentage of your company’s sales revenue that was attained through debit and credit cards. While a merchant cash advance gives you access to fast money, it often comes with extremely high interest rates.

Companies that take regular credit card payments, such as restaurants or e-commerce stores, make the best use of these types of small business loans.

Invoice Factoring

Invoice factoring is a form of accounts receivable financing. Your lender offers cash up to 80% of the value of your unpaid invoices. But instead of paying back the loan yourself, you sell your invoices to a factoring company, which makes its money by collecting the full amounts from your customers.

This type of loan is ideal for companies that need fast access to cash and have reliable customers. Reliability is critical because a factoring company collects your invoices, which can create issues if a client is late with their payment.

Equipment Financing

If your company needs to buy or lease equipment, this may be the right type of loan for it. You may use this financing when you need to purchase or lease costly assets, such as forklifts, solar panels, or even software for your company. These loans tend to have lower interest rates, with funds often arriving within 24 hours. However, you can only use this type of loan to fund equipment purchases.

If you choose to purchase the equipment, this type of financing acts as a loan that needs to be repaid with interest according to the predetermined loan terms. However, if you choose to lease the equipment, the lender owns the equipment and offers it on a long-term rental to your business. Since equipment leasing costs less in terms of monthly expenses compared to buying the equipment, many entrepreneurs tend to prefer equipment leasing over loans.

Where to Get a Small Business Loan

The most obvious sources of small business loans are major banks and government institutions. Though reliable, these organizations tend to have more stringent application criteria.

You may also borrow from alternative lending platforms that offer online loans, such as National Funding. These lenders offer several advantages:

  • Fast application processes
  • Rapid access to cash
  • Flexible Payment Terms
  • Simpler application criteria
  • Specialized loans tailored to your company’s needs

How Does Business Loan Repayment Work?

Now that you know how small business loans work, let’s switch focus to repaying your loan. How you repay varies depending on several factors, including the type of business loan you apply for and the lender you get the loan from.

Revolving Payments

You make revolving payments on lines of credit. The loan renews whenever you make a payment. For instance, you may have a line of credit up to $5,000, of which you’ve used $2,000. You make a revolving payment to clear the $2,000, giving you access to the full $5,000 again.

Payment in Installments

Traditional loans ask for repayments in regular installments. You agree on a periodical repayment, with interest attached, which you make for the entire loan term. Some installment loans allow you to repay early, though you may pay additional fees.

Cash flow-based Payments

The lender reclaims the money owed from your business cash flow. Invoice factoring and merchant cash advances both use this type of payment. Instead of paying directly, you pay via the revenue your company generates.

How to Get A Small Business Loan

Though the process of getting a small business loan may seem arduous, it’s not as difficult as it seems. What’s more, applying for a small business loan doesn’t have to take an eternity. Online lenders, such as National Funding, offer simple application processes and quick access to cash.

You need to choose the right lender and the right types of business loans for your company. Follow the steps in our “How to Get a Small Business Loan” article to ensure you apply for a loan that aligns with your needs.

Frequently Asked Questions (FAQs)

How much collateral is needed for a business loan?

The amount of collateral you need depends on the type of loan, loan amount, and what the lender determines after assessing your application. Lenders typically consider your company’s credit score, annual revenue, and risk analysis, along with the loan amount, when calculating collateral requirements.

Some lenders offer zero-collateral loans. These small business loans allow you to borrow without risking any of your personal or business assets.

How are small business loans paid back?

Your repayment method depends on the type of business loan. For example, invoice factoring involves selling your outstanding invoices for a portion of their value, meaning you face no ongoing repayments. By contrast, a working capital loan typically requires you to repay in monthly or weekly installments over a set period.

What disqualifies you from getting a business loan?

A lender may disqualify you from getting a business loan for many reasons. These reasons include having a poor credit score or being a new business that doesn’t have an established track record.

Alternative lenders are less likely to disqualify you than traditional lending establishments. In fact, SBA loans only have a 25% approval rate at large banks, with that rate only increasing to 49% at smaller banks.

Tags: ,