As a small business owner, it’s important to understand what financing options are available to you and how to take advantage of them to build your business. 

Depending on what you’re hoping to accomplish, some business loans may be better than others. Here’s what you need to know about how different types of business loans work.

What Is a Business Loan, and What Are They Used For?

Small business loans are a form of financing available from commercial lenders. Depending on the type of loan you get, there are a variety of uses, including:

• Launching a startup or franchise
• Expanding an existing business
• Funding everyday working capital needs
• Financing equipment or machinery for your business
• Making enhancements to existing equipment or machinery
• Buying office furniture and fixtures
• Investing in new products or services
• Acquiring another business
• Refinancing old debt
• Purchasing real estate

Before you decide to take out a small business loan, it’s important to understand what your needs are and how the loan can help you achieve your goals. In some cases, you may have multiple needs, while in others, you may only have one.

Take your time to flesh out your reasons for borrowing and how the loan can help your business grow. Then compare the different loan options that are available to you to determine the best fit.

How Do They Work?

There are many different types of business loans, and many of them work a bit differently than others. For example, with a term loan, you’ll get a lump-sum payment upfront and pay it back in fixed installments over a set period of time.

In contrast, a business line of credit offers you a credit limit that you can borrow against and pay back multiple times. 

The important thing to keep in mind is that small business loans always require repayment, typically with interest and sometimes with fees attached. As you compare the different options, you’ll want to choose the one that works best for your needs and your ability to repay.

You’ll also want to take a look at your cash flow and determine whether you might have difficulty repaying the loan after you’ve used the money. 

Many business loans require a personal guarantee, which means that if your business can’t pay back the debt, you may need to use your personal assets to do it.

What Are the Usual Requirements?

When you apply for a small business loan, you’ll typically undergo an underwriting process. This allows the lender to review your situation to determine how likely you are to repay the debt. 

While specific requirements can vary based on the type of business loan and the lender, many of them are relatively uniform.

Here’s what lenders will typically consider when you apply.

Personal and Business Credit Scores

Many commercial lenders will look at both your personal and business credit scores, especially if your business is relatively new and you have yet to open business credit file. 

In most cases, business lenders are looking for good credit scores, which can vary depending on the model the lender uses. For personal scores, a FICO score of 670 or higher is preferable, though some short-term, high-interest business loans may be available if your score is lower.

When you’re just starting out, it can be worth it to take out a loan just to build business credit. There are also vendors and other companies that can help you build business credit history. Over time, you’ll get more opportunities that don’t require a personal credit check.

Time in Business

New, small businesses have a relatively high failure rate, so many of the best business loans require that you have an operating history of at least two or three years. 

However, some business loans are still available to startups, and you may only need a few months to be eligible to borrow money.

And with options like business credit cards, you don’t technically need any operating history at all.

As you compare your options, make sure you look at the time-in-business requirements to avoid an unnecessary denial.

Credit Reports

Your credit scores are based on your personal and business credit reports, but they don’t always tell the whole story.

As a result, business lenders will request copies of your credit reports to see how you’ve handled debt in the past. 

If your score is in decent shape, but you’ve filed bankruptcy in the past few years, missed a payment, or have collection accounts, you may have a difficult time getting approved.

As a result, it’s crucial to check your credit reports before you apply for a business loan. Look out for factors that are hurting your credit score and any inaccurate information that you can dispute. 

This will give you the information you need to take action to address credit score issues.

Collateral

Many business loans require that you put up collateral to secure the loan. That way, if you default, the lender can seize the collateral and recoup its investment.

If you’re applying for an equipment loan, the collateral is typically the asset you’re using the loan to purchase. With other loans, you can use equipment, machinery, inventory, accounts receivable, or just about any other business you have.

Keep in mind, though, that you generally can’t use the same asset twice. Also, some lenders may place a blanket lien on all of your assets, which can limit your borrowing options until you pay off the debt. Check each lender’s policy before you apply to avoid blanket liens.

Business Finances

Your credit history tells a lender how you’ve handled debt in the past, but your business finances tell them whether you have the ability to repay debt in the future.

In addition to your profit-and-loss statement, lenders may also want to see your balance sheet and cash flow statement to get an idea of how well you manage your money and whether you may have a hard time keeping up with your payments.

Types of Business Loans and How They Work

There are many different types of business loans out there, each with its own set of purposes, benefits, and drawbacks. As you consider how to finance your business needs, here’s what you need to know about each type of loan and how it works.

SBA Loans

SBA loans are loans that are originated by private lenders but partially guaranteed by the U.S. Small Business Administration. There are several different SBA loan programs for different purposes, including term loans, lines of credit, and microloans.

Most SBA loans require that you have an operating history of at least two years and that you have good business credit history. However, microloans may be available for business owners with newer businesses. 

Smaller loans typically don’t require collateral, but if the amount is above a certain threshold, you’ll need to secure your financing. 

Interest rates on SBA loans are fixed, which means they don’t fluctuate with market rates and provide more certainty than variable interest rates.

You can use SBA loans for a variety of purposes, though those purposes can vary depending on the type of loan you get. 

But you can’t use it to consolidate debt, pay delinquent taxes, relocate, invest in real or personal property, make payments or distributions, or use it for loans to the business owner.

SBA loans typically offer low-interest rates and favorable repayment terms — some loans go as long as 10 years, or 25 years for real estate use. But it can take several months to go through the application process, so they’re not well suited for immediate financing needs.

If you’re considering an SBA loan, use the federal agency’s Lender Match tool to get matched with one or more lenders that can help meet your needs. 

Term Loan

Most term loans are offered by banks and credit unions. They tend to offer low-interest rates and long repayment terms, typically up to 10 years. 

These are installment loans, which means that you get a lump-sum payment upon approval, then pay that money back in fixed monthly installments.

Term loans are best for longer-term business projects to help you expand your business or acquire a new one. Loan amounts can vary by lender and your needs.

Banks and credit unions typically require that you have at least two years of operating history and good business and personal credit scores. Loans may be secured or unsecured, though secured loans tend to offer better interest rates. Those rates are generally fixed.

Uses for term loans are fairly flexible, though you’ll want to check with the lender to see if they have any restrictions. If you’re considering a term loan, take your time to shop around and compare local and national financial institutions to ensure that you get the best deal possible.

Working Capital Loan

A working capital loan is a business loan that’s designed to cover short-term working capital needs, such as payroll, rent, debt payments, and more. 

Business owners typically don’t use these loans to make long-term investments or buy long-term assets. As such, they typically have shorter repayment periods, ranging from a few months to a few years. Interest rates are typically fixed.

Like term loans, these are typically installment loans, which means you’ll get the loan amount upfront and pay it back over a fixed term. 

You may be able to get a working capital loan from a bank or credit union, but they’re also available from non-bank lenders, including online institutions.

Keep in mind, though, that non-bank lenders may charge higher interest rates and fees than banks and credit unions. With that, though, they may also have less stringent creditworthiness criteria, making it easier for newer businesses to qualify. 

Because working capital loans can be more expensive and have shorter repayment periods than term loans, it’s crucial that you make sure you can afford the monthly payments before you apply.

Business Line of Credit

A line of credit works differently than a term loan. Instead of giving you the full amount upfront, you’ll get a revolving credit line that you can draw from when you need it. 

Business lines of credit typically have a draw period and repayment period. During the draw period, you can take withdrawals from the line of credit up to the credit limit, pay it off, and do it again. 

During this time, which can be anywhere from a few months to several years, you typically only have to make interest-only payments.

Once the draw period ends, the lender will amortize the remaining balance and have you pay it off over a set repayment period. During this time, you won’t be able to take any more draws from the line of credit.

Unlike most business lines, lines of credit typically come with a variable interest rate, which means that the cost of borrowing can fluctuate over time. 

If interest rates go down over time, this can work in your favor. But if market conditions cause interest rates to increase, it’ll end up being more expensive for you.

Business lines of credit are offered by banks, credit unions, and non-bank financial institutions. 

While banks and credit unions can offer relatively low-interest rates and longer draw and repayment terms, expect higher rates and shorter terms with non-bank lenders — albeit with more relaxed underwriting requirements.

Merchant Cash Advance

A merchant cash advance (MCA) is technically not a business loan but a commercial transaction. This type of financing involves a provider giving you an advance on future sales. 

Traditionally, they’re based on your debit and credit card sales, though some MCA providers may base it on the inflows and outflows of your business bank account.

Instead of charging interest, MCAs charge a factor rate, which can range from 1.1 to 1.5. If you get a 1.5% factor rate on a $10,000 advance, that means you’ll end up paying $15,000 in total. 

Unlike traditional business loans and lines of credit, that interest amount is fixed, so you won’t get any savings if you pay off your MCA early.

In exchange for the advance, MCA providers will take a percentage of your daily credit and debit card sales or a set daily or weekly withdrawal from your bank account. If you get the first option, the amount of time it takes to pay off the advance will depend on your sales volume. 

The latter option typically has a fixed repayment period. At any rate, you can expect MCA repayment terms to range from three to 18 months.

MCAs typically don’t require collateral or a credit check because they’re based on sales figures rather than your creditworthiness. As a result, they also tend to be the most expensive form of business financing. It’s best to avoid them unless you’ve exhausted all of your other options.

Invoice Factoring

As with merchant cash advances, invoice factoring is also not considered a business loan. With this financing option, you sell your outstanding invoices at a discount to a factoring company, which, in turn, collects payment from your customers.

For example, let’s say you sell a $20,000 invoice to a factoring company for $19,400, and the company takes the remaining $600 as a factoring fee. 

You’ll receive 85% of the $19,400 upfront, giving you $16,490. Then, when the factoring company receives payment from the customer, you’ll receive the remaining $2,910.

Like MCA providers, invoice factoring companies typically don’t require collateral or a credit check. However, the factoring company may run a credit check on your customer and may even charge you late fees if your customer pays late.

In other words, you’re putting your finances in the hands of your customer, which could be a risky endeavor.

Equipment Financing

This type of financing is reserved specifically for purchasing equipment or machinery, including vehicles. Equipment financing functions similarly to an auto loan or mortgage loan, it uses the asset you’re purchasing as collateral to secure the loan.

These loans typically have lower interest rates as a result and don’t always require good or excellent credit. You’ll also typically get a repayment term that matches the expected life of the equipment, which can be several years.

Equipment loans are installment loans, giving you the amount you need to purchase the asset up front, then requiring regular payments until it’s paid in full. Note, however, that you may be required to make a down payment on the purchase to secure the loan.

There are many different types of equipment loans out there from banks, credit unions, and non-bank lenders, so make sure you shop around to find the best deal.

How to Pick the Right Loan for Your Business

If you need financing for your business, there are several different factors to think about before determining which loan is best suited for your needs:

• Eligibility: While it’s possible to get approved for a business loan, even if your business is relatively new or your credit is in poor condition, your options will be extremely limited. Your best bet is to have at least a couple of years of operating history, a strong business credit history, and good business financials.
• Purpose: Think about why you need the capital you’re seeking. If it’s for working capital needs, you likely don’t need a term loan with a long repayment period, and if you want ongoing access to capital, you may opt for a line of credit instead of a traditional loan. Think carefully about why you need the money and which loan best fits that need.
• Ability to repay: Short-term loans may be appealing, especially if you don’t have the credentials for a longer-term loan, but higher interest rates and higher monthly payments may increase the chances of default. Think about your ability to repay any debt you incur and how that monthly payment might impact your ability to do business.

How Hard Is It to Get a Business Loan?

Your ability to get a business loan is largely determined by your eligibility. Again, it’s possible to get a business loan as a startup with no business credit history or if you have bad credit, but your options will be limited, and the cost of borrowing will be much higher.

That’s not to say you shouldn’t borrow money when you’re just starting out. But be mindful of the costs and whether you can use that leverage to build your business or if it’ll increase your odds of failure.

Over time, work to build business credit — you can leverage your personal credit or build business credit without it — to make it easier to qualify for business loans and to secure more favorable terms for yourself.

The Bottom Line

Whether your financing needs are short or long-term in nature, small business loans can provide much-needed capital for your business. However, not all business loans are created equal, and it’s important to understand how each type of loan works and how it can help you.

Once you decide on the type of loan you want, you’ll also want to take your time to compare offers from several different lenders to ensure that you get the best deal. Depending on your current credit and financial situation, finding an affordable loan may be difficult. 

But as you take the time to build your business credit history and establish a strong financial track record for your company, it’ll become easier to obtain affordable financing when you need it.

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