Running a small business can be lonely and frustrating at times. But you are not alone on this journey of entrepreneurship. According to the US Small Business Administration Office of Advocacy’s 2022 report, over 33 million small businesses are operating in the U.S.
A 2016 study from the U.S. Bureau of Labor Statistics indicates that nearly one-third of businesses are forced to shut down by the third year of operation. Some of the common reasons why small businesses fail include cash flow issues, financing problems, a competitive market, lack of a business plan, no budget for marketing, and many more. To avoid business closures and to help their establishments sustain and grow, many entrepreneurs turn to small business loans.
As the name suggests, a small business loan is a form of business financing that provides capital to companies to run their operations smoothly. This type of business funding offers quick and immediate monetary relief to keep your business afloat during a financial crunch. Business owners looking for small business loans can reach out to traditional lenders like the government. institutions and banks or approach alternative lending online platforms.
Before you apply for small business financing, you must understand what the loan entails and how it works.
Important small business loan terms to know
Lenders charge interest on the small business loans offered to the borrowers. The amount of interest to be paid is determined by the interest rate which can be either fixed or variable. A fixed interest rate doesn’t change throughout the term period of the loan whereas a variable interest rate fluctuates as per the changes in the prime lending rate.
A loan term dictates the period within which the loan must be repaid to the lender. It denotes the duration of the loan repayment process. A short-term business loan ends in six to eighteen months whereas a long-term loan could last for a couple of years or even more.
Often, a traditional lender might require a borrower to put a business asset or equity as security for the loan. Such loans are called secured business loans, and the asset offered against the loan as security is called collateral. When a borrower defaults on loan payments, the lender can claim the business asset that was provided as collateral.
Repayment terms of a business loan indicate the terms and conditions that the lender has put across while providing the loan. It often includes the interest rate, loan term, repayment cycle, amount to be paid back on each repayment installment, prepayment options, and loan default penalties.
A term used frequently in business financing markets, working capital is the amount of money a business has to carry out day-to-day operations such as managing bills, paying employees, stocking inventory, etc. It is calculated by determining the difference between the assets and liabilities of a company. A lack of working capital can bring business operations to a standstill, so a lot of small business owners rely on financing to build their working capital.
Similar to collateral, a personal guarantee is also a form of security against the business loan. With a personal guarantee, a borrower puts forth personal assets as security for the loan, which the lender can take over in case of loan defaults.
What are Small Business Loans Used For
A small business loan can be used for more than resolving cash flow shortages or financial emergencies. A small business owner can utilize a loan for the following:
- Business Expansion Hiring & Payroll
- Storefront Renovation
- Equipment Purchase & Lease
- Stocking Inventory
- Paying Bills
- Debt Consolidation
- Business Marketing
- Building Working Capital
- Compensating Unpaid Customer Invoices
Benefits of Small Business Loans
Other than the obvious advantage of monetary boost that small business loans provide to your business, there are a few other pros of choosing this type of business funding:
- Fast Approval: Most lenders understand the urgency of businesses applying for small business loans. That’s why lenders strive to speed up the approval process and disburse the loan amount ASAP. Compared to some traditional lenders, alternative lenders and online lending platforms offer fast approval for loans (within 24 hours in some cases).
- Simple Qualification Criteria: Most lenders are transparent about their qualification criteria for the loan, and it is pretty straightforward in most instances. The lender will scrutinize the borrower’s credit score, credit history, risk profile, income tax returns, and other major financial documents to determine if the borrower qualifies for small business funding.
- Loans Tailored to Borrower’s Needs: Depending on the purpose of applying for a loan, a borrower can choose from different types of small business loans. Many online lenders offer loans specifically for business expansion, payroll management, equipment purchase, etc. Apart from these types of loans, lenders are becoming more flexible towards customizing loan terms to suit the borrower’s requirements.
Types of Small Business loans
Working Capital Loans
A working capital loan can be used to cover short-term cash flow issues with your business. It temporarily boosts your company’s working capital and allows you to manage day-to-day business activities with ease.
Line of Credit
Often offered by commercial banks, a line of credit is a revolving loan where the borrower has access to a lump sum amount up to a certain limit. The borrower can then withdraw money from this credit line as and when they need it. Once they repay the utilized credit, they get access to the full amount of credit again.
Equipment financing is a special type of small business loan that can only be used toward obtaining critical equipment for your business. If you wish to buy the equipment, you can apply for equipment loans whereas if you just want to use the equipment on a long-term rent, you can apply for equipment leasing.
SBA stands for Small Business Administration. It is a government organization that works toward streamlining small business loan guidelines to simplify the application process for borrowers and reduce risks for lenders. SBA loans are secured loans offered by traditional lenders, where the security is a guarantee from the government that it will repay the lender if the borrower defaults.
Businesses dealing with late payments and unpaid invoices from customers could utilize accounts receivable financing to keep their business running. Through receivables financing, you can get a loan of up to 80-85% of the unpaid invoice amount that you need to repay with interest.
In this type of financing, you can sell your unpaid invoices to an invoice factoring company and get up to 80% to 90 % of the invoice receivables amount. The invoice factoring company will directly collect payments from your customers, but if your customers aren’t reliable you may still be liable to repay the factoring company.
Short-Term Business Loans
You can apply for short–term business loans to resolve any temporary money problems affecting your business. This type of small business funding has a term period of six months to 18 months, and it can help your business during periods of seasonal sales slumps.
If your business sells physical products, you would understand the impact of inventory management on your business. This type of loan provides you with capital to stock up on inventory and deliver products to meet the demands of your customers. It helps you to run your business smoothly even during times of financial uncertainties.
How Small Business Loans Work
The process of acquiring small business loans is fairly simple and transparent. When you apply for a small business loan, the lender will examine your application to determine if you meet the qualification criteria for the funding. It generally involves the lender reviewing your personal & business credit scores, your business’ years of operation, the industry of your business, your profit statement, and income tax returns among other financial documents. If you meet the loan qualification criteria, the lender will offer the business loan with terms and conditions that determine the loan amount, interest rate, loan term, repayment cycle, and collateral requirements if any. Read our article on how small business loans work to know more.
How to Get a Small Business Loan
Choosing the small business loan that is right for your company can be tricky. It all starts with determining what type of business loan you need and the lender you choose to work with. Before you apply for financing, you must know the loan amount you need and figure out what loan terms, repayment terms, etc. would be favorable to your business. You must gather all financial documents that the lender might require such as an annual revenue statement, proof of business ownership, credit score, etc.
Before you check with the lender about their collateral conditions, you must evaluate if you can put forth collateral if needed. Talking to the lender’s funding specialist will help you clear all your doubts about the business loan before you apply. To know more, read our article on how to get a small business loan.
Frequently Asked Questions
Do small business loans require a credit check?
Most lenders would conduct a thorough credit check to determine the risk of offering a loan to your business. There might be a few that offer financing of small loan amounts without credit checks but the interest rates tend to be high with such loans.
What is the most common type of small business loan?
Most small business owners apply for either SBA loans offered by traditional lenders or short term business loans offered by alternative lenders.