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How Do Business Loans Work?

Written by Banks Editorial Team

Updated April 14, 2024​

6 min. read​

how do business loans work

As a small business owner, you likely have some big ideas for how you want to grow your business and make it the best it can be. Whether you’re interested in purchasing some new equipment, hiring new employees, or purchasing real estate, you’ll likely need some financial support to take such significant steps.

Business owners can use their cash flow to support initiatives, but what if your profits fall short of what you need to expand and grow? A small business loan can fill the gap and provide the funding you need.

A business loan is a type of credit and functions similarly to a personal loan. With a business loan, you borrow a set amount of money from a lender. Then, over time, you pay that money back with interest. Here, we’ll cover some of the common business loans and how you can use them to grow your business.

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Common Types of Business Loans

Banks, credit unions, and online lenders let business owners choose among several types of business loans. Understanding how each of these loans works can help you determine the right financing method for your company’s goals.

While there are many different types of business loans, below are some of the most common and most helpful to small business owners.

Working Capital Loans

One of the most versatile types of business loans is a working capital loan. This type of loan is an excellent option for many small businesses because the loaned funds can be used for operating expenses.

Working capital is the money a business uses to operate day to day. For example, your working capital may go to pay bills, pay an employee’s paycheck, pay a vendor’s invoice, or cover other operating costs.

If your business has uneven cash flow or you need a little extra money on hand to finance your business growth, a working capital business loan could be just the right option.

Because a working capital loan is intended to be used to finance day-to-day operations, you should view it as a short-term loan. As a result, working capital loans generally provide lower loan amounts than other choices on this list.

Business Term Loans

Business term loans are incredibly common and allow you to make predictable monthly payments. A term loan is the most basic loan and functions almost exactly like a personal loan would. With a business term loan, you’ll go through an application process to receive approval from the lender to borrow a set amount of money.

Once approved, you’ll receive a lump sum soon after. Then you’ll begin repaying the money on a set schedule. In addition to repaying the money borrowed, you’ll pay interest just like you would with any other loan.

The interest rate and term of the loan will depend on your lender and your own situation. You can reduce your interest rate with a strong credit score and a lengthier loan term. Lenders perceive both as a lower risk.

The loan term plays a critical role in determining your monthly payments. Adding more years to the backend of your loan will increase the loan’s lifetime interest payments. However, as you spread the loan’s repayment over more years, you’ll reduce your monthly payment. Businesses focusing on cash flow optimization should get loans with longer terms. If you want to get out of debt sooner, you should opt for a business-term loan with fewer years. This route results in higher interest rates, but you pay less interest over the loan’s lifetime since you pay it off sooner.

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SBA Bridge Loans

SBA loans are the cream of the crop of business loans. The U.S. Small Business Administration (SBA) partners with financial institutions and online lenders to provide competitive loan terms for qualifying small business owners. Generally, an SBA loan has the best terms and the lowest interest rates. However, while SBA loans have desirable terms, they have a lengthy application process. It can take 30-90 days to receive funds after submitting your application.

SBA loans are guaranteed by the Small Business Administration, which is why they have more favorable terms. However, the lengthy application process and more stringent requirements make them more difficult to obtain. If you have the time and you are able to qualify, this type of loan is a good idea for many small and medium-sized businesses.

If you need quicker funding, you may be better off applying for a standard business term loan. That said, the SBA offers a solution for small business owners who want an SBA loan but need funds sooner than the standard approval window would allow. It’s called an SBA bridge loan.

An SBA bridge loan is a type of business loan that can act as a buffer while you wait for your SBA loan approval. An SBA bridge loan ‘bridges’ the gap between your need for funding and receiving approval for an SBA loan. It provides quick access to funds and a backup plan if you don’t get approved for the SBA loan. Even if you don’t qualify for the SBA loan, you can continue using funds from your SBA bridge loan for up to 12 months.

Business Line of Credit

A business line of credit is a loan you can use for short-term needs. Business owners can borrow against their credit limit and repay the loan on a more flexible schedule. Since a line of credit only charges interest on what you draw against it, you don’t have to pay interest right away. You can qualify for this loan and never pay interest at all if you don’t borrow against the credit limit. It’s a useful reserve to have in case you need to borrow money quickly.

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Invoice Factoring

Invoice factoring is a funding strategy that turns your unpaid invoices into quick cash. You can sell your invoices to a third party who pays a percentage of the invoice’s face value. Invoice factoring companies look at your customer’s ability to repay the invoice when assessing how much to provide for the invoice. One of the key advantages of invoice factoring is that you do not go into debt for this option.

What Do Lenders Look for to Approve a Business Loan?

Before jumping into the loan application process, it’s important to understand the different qualifications your business must meet to get approved for a business loan. Each lender you apply with will have slightly different qualification requirements. Lenders use these requirements to protect themselves and small business owners. A small business owner defaulting on a loan is the worst-case scenario for both parties. Lenders will lose a lot of money, and the business owner may lose their company. Loan requirements minimize the likelihood of those outcomes.

Below you’ll find the basic qualifications that most lenders look at to assess if a business can repay the loan.

Credit History

One of the first things most business lenders will look at during the loan approval process is your credit history. Your credit history provides a snapshot of your ability to manage financial obligations. Lenders can see the following details in your credit history:

  • Your personal credit score
  • The debt you currently hold
  • Your loan repayment history and consistency
  • Any bankruptcy or foreclosure records

Lenders strive to understand your overall credit health and ability to take on more debt.

A lender’s goal is to make money, which only happens if you repay your loan in full plus interest. Therefore, lenders try to minimize the risk by assessing a business’s credit history before extending a loan offer.

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Business Revenue

Another way that a financial institution will assess your ability to repay a loan is by looking at your company’s revenue. Your business revenue is the amount of money your business brings in during a calendar year. Lenders have different requirements, but some may request the past two years of your company’s revenue history. These documents can help a lender determine if your cash flow and revenue are reliable. Some small businesses can post a strong month or two but have uneven revenues overall. By looking at two years of data, lenders gain a better indication of what a potential borrower can afford.

Debt Obligations

Another factor that lenders consider is your business’s debt obligations. Your debt obligations include any outstanding debt you or your business holds. Debt would include unpaid credit cards and other loans.

If your business has a high amount of debt, it will make it more difficult for you to be approved for another loan. Most financial institutions use a standard calculation to compare your business revenue and current debt obligations to determine whether you can afford more debt.

Some businesses have solid balance sheets and good credit, but a company with too many loans can deter lenders. Lenders look at a company’s debt-to-income ratio to assess if the business owner can handle more debt.

The debt-to-income ratio measures the percentage of your income that goes toward debt payments. For example, if your business generates $10,000 per month, and you spend $6,000 per month on loan payments, you have a 60% debt-to-income ratio, which wouldn’t be good. Your debt-to-income ratio should be under 50%, but an even lower ratio will help you qualify for higher loan amounts and better terms.

Available Collateral

Some business loans require collateral. Collateral is an asset that the borrower uses to guarantee a loan. The most common types of collateral are real estate and equipment. Collateral gives the lender something they can seize and sell if you cannot repay the loan, helping to protect them from losses.

If your business doesn’t have a lot of credit history or you have a low credit score, putting up collateral can help you to obtain a secured business loan. Although some business owners may not like providing collateral, it may be the only choice for some companies. It can also help you get a lower interest rate. This is because financial institutions and online lenders set interest rates based on the applicant’s perceived risk and their desire to generate profits from their capital. When you offer collateral, the risk shifts from the lender to you, resulting in more favorable interest rates.

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Business Plan

Some lenders will take a look at your business plan before giving you a loan. Your business plan helps lenders understand the direction of your business, how you intend to use the capital, and what growth opportunities you intend to pursue. If your loan application requires a business plan, you should include the following details:

  • A description of your business
  • Information about your product or service
  • Market analysis
  • A write-up about your management team
  • How you plan to market your business and increase sales
  • Your financial projections and plan for using the loan

A business plan helps the lender to get to know you and your business, which can help it decide whether to offer you a loan. A business plan can also indicate you are a serious business owner and give the lender reassurance.

Where to Get a Business Loan

Small business owners can get loans from many financial institutions and online lenders, but it’s critical to first understand why you need a loan and which one is the best fit for your company. Once you determine these details and are ready to get started, the next step is working with a lender. Look for an online lender that offers no-obligation business loan quotes with favorable terms and competitive rates, as well as faster funding. And don’t be afraid to shop around.

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