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How Does a Small Business Loan Work?

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Updated October 19, 2023​

7 min. read​

Small business owners make ambitious investments to reach new customers, increase productivity, and accomplish other objectives. Some of these purchases can come from your business bank account, but other investments require a loan. You may not have enough cash in your checking account to buy a commercial property, a new piece of equipment, or something else that your business needs.

Small business loans close the gap and let you acquire a new asset. Many companies use financing to get what they want, even if they don’t have enough money right now. The business owner gets the necessary capital and agrees to pay it back over a predetermined term. Understanding how small business loans work can help you save money and access enough capital to make your next investment.

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Overview: Small Business Loans

Companies can choose from several types of small business loans, but they all fulfill the same objective. Each loan gives you proceeds you can use for any business expense or investment. Lenders do not need to know how you will use the funds unless you are buying an asset that becomes collateral for the loan. 

Every small business loan has a term that reveals the monthly payment, interest rate, number of years on the loan, and other details. Some loans have fixed monthly payments that will continue showing up in your budget until you repay the entire loan. Other loans have a more generous payment plan in the beginning, but interest will accumulate on the unpaid debt. All debts eventually become due, and some loans have different repayment models.

How Does a Small Business Loan Work?

A small business loan gives your company the necessary capital to make investments. You then have to repay the lender with interest. The interest rate and fees represent the lender’s return on investment. Lenders want to make additional revenue to reflect the risk they take on for providing the capital to a business owner. 

Lenders offset some of the risks by requiring collateral or a personal guarantee for their loans. Collateral is an asset you must give to the lender if you cannot repay the loan. You only need collateral for a secured loan, and while it increases the borrower’s risk, it also results in a lower interest rate. Anytime a lender offsets risk to the small business owner, that owner ends up getting a better deal.

Unsecured loans are the other type of small business loan, and they do not require collateral. That’s the main distinction between secured and unsecured loans, and every financial product falls within one of these two categories. Some business lenders may require a personal guarantee if you opt for an unsecured loan. The personal guarantee states that a borrower must use personal assets to make the monthly payments if the business does not generate enough revenue to keep up with the loan payments. A personal guarantee can lower your interest rate, but not all unsecured loans have this requirement.

Why do business owners incur additional risk for lower interest rates? Your interest rate plays a big role in your monthly payments. Getting a 5% interest rate instead of a 6% interest rate can save a company thousands of dollars over a loan’s duration. Lenders will look at several resources to determine your interest rate, but your credit score and annual revenue will get prioritized. 

The lender decides your interest rate, but you get flexibility over the loan’s duration. Adding more years to your loan will increase the lifetime interest payments, but it will also decrease your monthly payments. Therefore, you can preserve more of your cash flow by opting for a lengthier loan. If you want to get out of debt sooner, a loan with fewer years on it is the better choice, but you will have higher monthly payments. If you want to make any changes in the future, you can refinance your loan, a process that changes the interest rate, terms, and monthly payment.

How Each Type of Small Business Loan Works

Every small business loan is secured or unsecured, but there is plenty of variety within those two categories. Small business owners frequently use these types of loans to obtain financing, and it’s a good idea to know the differences between each one.

SBA Loan

The SBA loan is a desirable loan because of its competitive interest rates and reasonable terms. The U.S. Small Business Administration 7(a) loans let business owners borrow up to $5 million, which is higher than most loans. You can get competitive rates from other loans, but SBA loans are among the best. However, it’s not for everyone due to the stiff requirements and lengthy wait time. Some lenders offer more flexibility than others, but you may need a 690 personal credit score to qualify and at least two years of business experience. Lenders also set higher revenue requirements for SBA loans than for other financial products.

If you get approved, you will have to wait 30-90 days to receive funds. Businesses that need funds right away should consider another option. Other small business loans have 24-72 hour turnaround times, giving them a significant advantage over SBA loans. Before you can even apply for an SBA loan, you must be a small business based on the SBA’s definition and have tried to get alternative financing elsewhere first. 

Term Loan

A small business term loan gives you an upfront lump sum that you have to pay back each month. Most business owners use a fixed interest rate for their term loans. This fixed rate results in consistent monthly payments that stay the same for the life of the loan. A consistent payment can make it easier to plan for monthly loan payments in your budget. 

Some business owners may opt for a term loan with a variable interest rate. This rate may start out lower than a fixed interest rate, but your payment isn’t as stable. Rising interest rates will increase the variable rate on your loan and result in higher payments. Business owners who use variable-rate loans hope that interest rates will fall or stay the same over the loan’s lifetime. 

The interest rate isn’t the only factor that determines your monthly payment. The borrower decides on the loan’s duration, and adding more years will reduce your monthly payments. If you want more years on your loan, it’s better to use a secured loan with collateral. It’s easier to get a loan with a 10+ year duration with a secured loan than an unsecured one.

Business Line of Credit

A business line of credit is usually easier to obtain than a business term loan. This type of financing tends to have a lower credit score requirement, and the repayment term is more generous. Instead of making fixed monthly payments on the debt, you only have to make minimum monthly payments, just like a credit card.

Every business line of credit has a draw period where you can make interest-only payments. This is more affordable than a business term loan, but after the draw period, the remaining balance converts into a business term loan. Then, you will have to make monthly payments on the remaining debt. The draw period gives you more time to realize returns on your investment before monthly payments are due.

During the draw period, you can borrow as much capital as necessary up to the credit limit. The credit limit is a set cap on how much you can borrow and functions like a credit card. A small business owner only pays interest on capital borrowed against the credit limit. For example, if you have a $100,000 line of credit and borrow $40,000 against it, you only pay interest on $40,000. When the draw period ends, you will only have to repay $40,000 plus interest. Most business lines of credit feature a variable interest rate, but some offer fixed rates.

Equipment Financing

Many businesses need equipment to increase productivity and perform their services. Equipment financing makes it easier to acquire equipment even if you don’t have enough capital. The equipment becomes collateral for the loan, which increases your risk but also results in a lower interest rate. Some lenders don’t require you to put any money down, and most of these loans are between 3-7 years.

Many business owners use equipment financing once they are settled in and ready to commit many years to the business. Equipment financing helps you escape the cycle of monthly lease payments. Each monthly payment on your equipment loan gives you more equity, and those monthly payments go away at the end of the loan. If you rely on equipment leases, the monthly payments never go away. The lessor can also raise the lease payment at the end of the year, putting more pressure on your cash flow in the process. Equipment financing lets you escape this scenario and own your equipment.

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Working Capital Loan

A working capital loan is a short-term loan business owners use to cover operating expenses. Some business owners may have to draw from these funds during slower seasons. Businesses in summer destinations make most of their sales in the summer, but they still have to cover operating expenses during the offseason. 

Working capital loans make operating expenses more manageable, but they aren’t the best for long-term investments. You can choose between a secured or unsecured working capital loan. The secured loan will have a lower interest rate, but you will have to designate collateral for the loan.

Invoice Factoring

Small business loans give you extra capital, but you also have to make monthly payments. Those monthly payments minimize your cash flow and can become stressful. Invoice factoring is one of the few financing solutions that does not increase your debt. Instead of taking on another financial obligation, business owners sell their unpaid invoices to an invoice factoring company. The business owner receives a percentage of the unpaid invoice’s face value upfront, and the factoring company realizes profits through a fee and collecting the invoice payment.

You can walk away from invoice factoring without a monthly payment, and it’s great for people with bad credit. Factoring companies look at your customers’ credit scores instead of your own. 

Merchant Cash Advance

A merchant cash advance can get expensive in a hurry, and it’s not the best option. With that in mind, some business owners pursue this option because it has generous credit score requirements. You might get denied for every financial product except this one. You have to repay the loan based on a percentage of sales generated from debit and credit card transactions. The lender also uses a factor rate to determine how debt will accumulate over time. This is not the best financing choice, but for some, it’s the only one left. Merchant cash advances aren’t as bad as payday loans, but they are close.

Is It Hard to Qualify for a Small Business Loan?

The difficulty of receiving a small business loan depends on the lender and your financials. Some lenders have challenging requirements, while others are more generous with their credit scores and revenue conditions. However, if you get a loan meant for people with lower credit scores, you may end up with a higher interest rate.

Should You Get a Small Business Loan?

Some companies need small business loans more than others. If you can cover your expenses with revenue, you may not need a loan. However, if your business is cyclical or you want to make a big investment, a small business loan may be a good idea.

How to Get a Small Business Loan 

Many banks, credit unions, and online lenders offer small business loans. You can visit their websites to learn more about the application process and what lenders expect. It is a good idea to review several offers before selecting a small business loan for your needs. Reviewing several choices can help you secure a lower interest rate and more reasonable terms. In addition, building your credit score during this search can result in better financing when you get a small business loan.

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