Do you need extra capital for your small business? A small business loan can help with slow seasons, big investments, and everyday expenses. You can choose from many lenders, but they don’t hand out loans freely. Instead, lenders impose requirements to minimize their risk and increase the likelihood of getting repaid in full. Knowing the requirements makes the search process easier and can help you filter out available lenders.
What Can You Use a Small Business Loan For?
Business owners take out loans for various reasons. Some borrowers want to open another physical location and need a commercial mortgage to acquire a property. Other business owners need to buy new equipment due to the rising demand for their services. Unfortunately, banks, credit unions, and financial institutions will not ask how you intend to use the loan.
You can use the funds for any purpose, but some secured loans used to acquire assets are the exceptions. For example, if you take out a commercial mortgage for a property, the lender expects you to buy the property with the funds. If you want to take out an equipment loan, you will have to use the proceeds to buy the equipment you mentioned to your lender. When you aren’t using the loan to purchase collateral, you can use the funds for any purpose. Lenders won’t check in on you as long as you make on-time loan payments.
Typical Requirements for a Small Business Loan
Each small business lender has requirements, and while there are similarities, the standards vary. Some lenders expect their borrowers to have excellent credit, while others welcome borrowers with bad credit scores. Reading the requirements before applying for a loan can save you a hard credit inquiry if you do not fulfill the criteria.
Credit Scores (Personal and Business)
Most lenders will check your credit score through a hard credit check before giving you a loan. A few lenders will forgo this common procedure, but that approach typically yields the highest interest rates in the industry. Some business lenders will only request your personal credit score, while others will want your personal and business credit scores.
A higher credit score grants you more choices, favorable terms, and lower interest rates. A credit score above 700 will open up most loan options, but you can still get a loan if your personal credit score is in the 500s and 600s. A credit score in the mid-600s still opens up many types of loans, but it becomes more difficult if your score is below 600.
Traditional banks and credit unions have the most challenging credit score requirements. However, consumers with lower credit scores can find viable choices by checking out online lenders. Some of these lenders emerged during the recession as they recognized the millions of borrowers traditional banks had left behind.
Building your credit during the loan application process will help you get better terms and rates. If you don’t need a loan for a few weeks, it’s possible to add a few points to your credit score through on-time payments and trimming debt.
Some lenders will review your business plan during the loan application process. This short document helps a lender assess how you will use the capital and the likelihood of getting repaid. Lenders may feel wary about giving loans to business owners who do not have clear plans.
Not every lender requires a business plan, but it’s still good to create one for your company. A business plan is a compass that guides the business owner through challenges. It reveals objectives and paths to success. Business plans also incorporate competitive research, which can help you discover new markets and opportunities. Finally, you can refer to this plan and make changes as you make progress and approach milestones.
Annual Revenue/Cash Flow
Lenders will review your documents and financials to determine if you can repay the loan and keep up with monthly payments. Your annual revenue numbers help lenders gauge your current ceiling, and cash flow lets them see how much money is left over. Many lenders set minimum revenue requirements and will look at your financials to determine if you can make the monthly payment.
The annual revenue and cash flow requirements vary for each lender and the type of financial product you want to use. Some lenders have a $10,000/mo revenue requirement for term loans and a more reasonable $5,000/mo revenue requirement for business lines of credit. If the lender does not have an annual revenue requirement, you can expect a higher interest rate than average. While the high-interest rate isn’t ideal, lenders without annual revenue requirements make it easier for startups to obtain financing.
Years in Business
Business owners are more likely to make mistakes at the beginning of their journeys. Beginners may have endured recessions, bad investments, and other malefactors as employees at other companies, but it’s different as a business owner. You are the person who makes the decisions or decides who will make key choices that impact your business.
Since there is more uncertainty and a higher likelihood of a new business owner making bad judgments, some financial institutions require business experience. Many traditional banks and credit unions want you to have at least two years of business experience to receive a loan. Some online lenders have more generous requirements, such as 6-12 months of experience. The necessary business experience varies for each lender and the type of loan.
Some lenders provide financing for startups and do not require any business experience to get started. You may also have success with getting a personal loan that you use for business investments. Some business owners have to pursue this option if they do not have any experience.
Size and Industry
Lenders don’t stop at reviewing your company. Financial institutions will also look at your company’s size and industry to determine the appropriate terms. A larger company can typically secure better loan terms than a smaller company. In addition, gaining market share makes you a more attractive borrower since lenders feel confident about getting their money back.
Large companies benefit even more if they are in less risky industries. Financial institutions have experience with many types of businesses, and they know which businesses pose higher risks. Construction and mining businesses have more obstacles than real estate and healthcare businesses. Companies in the healthcare and real estate sectors tend to enjoy lower interest rates and higher approval odds than businesses that specialize in construction and mining. You can’t control the industry you’re in, but expanding your business can open up better financing options.
Some business owners take out multiple loans and have to cover several loan payments each month. While multiple loans give your company more capital, those extra expenses can dissuade lenders from giving you additional funds. Lenders look at a metric called the debt service coverage ratio to determine if your business can reasonably cover the new loan and current debt obligations. This ratio reveals the percentage of annual net operating income that gets allocated for debt payments.
If you have a net operating income of $125,000 and pay $100,000/yr in debt, you have a 1.25 debt service coverage ratio. A 1.25 DSCR is the minimum for SBA loans, and you will need a higher DSCR to get more loans and better terms. A DSCR near or below 1 indicates a company struggles to keep up with debt. Lenders may work with borrowers with low DSCRs if the economy is doing well. However, financial institutions often tighten the DSCR requirement during recessions.
Most lenders make an effort to pass some of the risks onto the borrower. This extra incentive gives borrowers more reasons to stay on top of the monthly loan payments. The incentive depends on the type of loan. A secured loan requires collateral, assets that you must give to the lender if you cannot make loan payments. Commercial mortgages and equipment loans often turn the acquired asset into collateral that backs the loan.
If you opt for an unsecured loan, you will probably have to make a personal guarantee. A personal guarantee is an agreement to make monthly loan payments with your personal assets if you cannot keep up with loan payments using your company’s revenue. Personal assets can include selling personal investments (i.e., stocks and real estate), cash in your personal bank account, or any other asset. You get to choose which personal assets you use for the personal guarantee if it becomes necessary.
How Can a Small Business Loan Help Your Business?
More money gives you more choices. You can buy more equipment, hire more workers, increase your ad impressions, and tap into other investments. A small business loan gives you additional capital if your cash flow and reserves fall short. A small business loan will not solve every problem. Loans don’t fix unprofitable business models and can make them worse. However, if you have a good model in place, financing can make a positive impact on your company.
You can purchase assets with a loan, but there’s another benefit to getting capital from a lender. Many businesses are seasonal and do better in some months than others. A loan can keep companies afloat during slower months. The extra capital can also go toward inventory and other resources that put the company in a better position during the busy season.
Small business owners thrive on creativity, and capital lets them test more ideas and refine their systems. Using a loan productively has many possible outcomes that can help your company gain market share and revenue.
Where to Get a Small Business Loan
Does the sound of a small business loan excite you? Those funds can help with investments or alleviate financial stress, but how do business owners get these financial products? Many banks, credit unions, and online lenders offer small business loans. It is a good idea to shop around and look at several loan offers before choosing the right one for you.
When looking at lenders, pay attention to their requirements. Some lenders cater to borrowers with bad credit, and these may be better solutions if your credit score has taken a hit in recent months. Each small business lender has several types of loans. The interest rate, payment plan, and terms depend on which loan you select. A business term loan has monthly payments, while a line of credit has a more generous draw period in the beginning. Business owners also have to consider if they want fixed or variable interest rates. Fixed rates stay the same over the loan’s lifetime, while variable rates fluctuate based on how market rates change over time.
You can visit several lenders’ websites and reach out to your favorites to learn more about the next steps. Many websites are simple to use, and you can contact a representative if you have any questions.