How Do Business Loans Work?

Written by Banks Editorial Team
3 min. read
Written by Banks Editorial Team
3 min. read

You have the perfect idea for a new business but can’t afford to get the ball rolling. Or maybe you have an established business, and money is tight, or you need funds to expand. Either way, a small business loan could help you to get the ball rolling and move your plans forward. But before you start applying, it’s vital to get an understanding of how they work, so you’ll know which options are most suitable for your company.

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What Is A Small Business Loan?

As the name implies, a small business loan is a funding source that caters to business owners. They come in many forms and are available through many banks, credit unions and online lenders. 

How Do Small Business Loans Work?

It depends on the type of business loan and the lender you select. Below, you’ll find a comprehensive list of small business loan options and a breakdown of how they work:

Types Of Small Business Loans

Term Loans

A term loan is an installment loan that generally offers an affordable fixed interest rate, assuming you have good or excellent credit. Borrowers with low credit scores may qualify, but the interest rate will be higher. 

You’ll get a lump sum of cash, payable in equal monthly installments over a set period of up to five years. Some lenders offer extended loan terms to make monthly payments more affordable, but you’ll pay more in interest. 

Short Term Loans

Short-term loans behave like term loans and have more brief repayment periods. However, they’re usually for smaller amounts and come with slightly higher interest rates. Still, you can save on interest, considering you’ll pay off the loan faster than you would if you had a traditional term loan product. 

Business Line Of Credit

A business line of credit operates like a credit card. You’ll get access to a pool of cash that you can pull from on an as-needed basis during what’s referred to as the draw period. Most lenders also require interest-only payments during the draw period. And when it ends, the remaining amount that’s owed is converted to a loan that’s payable in monthly installments that could fluctuate over time since the interest rate is usually variable on business lines of credit. 

SBA Loans

SBA Loans are government-backed loan products between $500 and $5.5 million with affordable interest rates. However, they often require loads of paperwork, and the application process for some SBA loan products can be lengthy. Contrary to popular belief, these loans are not available directly through the U.S. Small Business Administration. Instead, you’ll work directly with an SBA-approved lender to secure funding. 

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Equipment Loans

Equipment loans are secured, which means the equipment you purchase with the loan proceeds is used as collateral. So, if you default on the loan, the lender has a right to take the property and sell it off to recoup what they’re owed. Still, this form of financing is worth considering as the interest rates are considerably low compared to other loan products.

Business Credit Cards

Business credit cards work like personal credit cards, but with increased functionality. Most allow you to categorize transactions, and you could also earn rewards and cashback. Depending on the card you apply for, you may also get an interest-free promotional period.    

Merchant Cash Advance

Merchant cash advances technically aren’t a loan but a form of financing based on your projected sales volume. If you’re eligible, the lender will give you a lump sum of cash and collect what they’re owed by taking a set percentage of your credit or debit card sales each day. 

It’s relatively easy to qualify for a merchant cash advance, but the fees could make the cost of borrowing outweigh the benefit of getting the cash you need. To illustrate, if you’re approved for a merchant cash advance of $25,000 with a factor rate of 1.5, you’ll pay $12,500 in fees. 

Invoice Factoring

Invoice factoring entails selling your invoices to a lender in exchange for immediate payment. You’ll pay a fee to sell your receivables, and the lender will pursue payment for what’s owed. 

Working Capital Loans

Working capital loans are designed to cover operational costs. They’re generally for a smaller amount and shorter repayment period than you’ll get with a term loan. And the interest rate you receive is usually determined by your personal credit score. 

How To Get A Small Business Loan

Most lenders require the following when you apply for a small business loan:   

Business Plan

Not all lenders require a business plan, but it doesn’t hurt to have one on hand just in case. It should include an overview of your business, a description of the products and services you offer, a list of key officers and managers, a market analysis, a sales and marketing plan, and financial projections. 

Business Financials

The lender may request these documents: 

  • Bank statements for the last three to six months
  • A profit and loss statement
  • A balance sheet 
  • Your two most recent business and personal tax returns
  • A schedule of business debts 

Quick note: This list is not all-inclusive. Consult with your lender to learn more about the documents you need to apply for a loan. 

Credit Scores

Most lenders will check your personal and business credit scores to determine if you’re a good fit for funding. If you haven’t yet established business credit,   

Collateral

Not all small business loans require collateral to get approved. But if you’re seeking a loan for an acquisition related to equipment, inventory or real estate, it could be a requirement. 

Where To Get A Small Business Loan

It can be stressful to find a small business loan that meets your company’s needs. Fortunately, lenders are plenty and with online technology available, you won’t need to leave your house to review, compare and find a business lender.

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