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How Do Small Business Loans Work

By DeVry University

November 3, 2022

10 min read

How Do Small Business Loans Work

Small businesses have often been described as the backbone of the American economy. According to the U.S. Small Business Administration (SBA), they’ve accounted for 62% of net new job creation since 1995, and make up nearly half of the private workforce in the United States. 

For startups and small businesses alike, small business loans can be a lifeline when it comes to financing new equipment or sourcing the supplies you need to make your company run. 

So how do small business loans work? Understanding how to you can get approved for a small business loan is much easier when you’ve done your research and become familiar with the options available to you. It’s important for small business owners and managers to develop an understanding of how business lending works, the different types of small business loans, the lenders offering them and some of the costs involved with loan repayment. 

What Is a Small Business Loan?

A small business loan is a type of commercial financing that qualified businesses can obtain from traditional lenders like banks, or non-traditional lenders such as online lenders or credit unions.

This type of loan can be used for many different purposes, but the borrower must let the lender know what the money is to be used for when they apply. Some common uses of the capital from a small business loan include covering the cost of starting or acquiring a business, commercial real estate purchase or remodeling, cash flow, debt consolidation, purchasing equipment or inventory, finding a business expansion or providing the money to meet other short-term obligations while you get your business up and running.

In general, business lenders will not allow you to use business loans to cover personal expenses like a home, vehicles for personal use or other items unrelated to the needs of your business. Regardless of the type of loan you receive, paying the loan back on time should be a top priority to preserve your personal credit and protect any assets you may have had to put up as collateral.

Type of Business Loans

Every small business owner should be familiar with the different business credit options available, some of which are:

Accounts receivable financing 

Also known as factoring, this is a form of short-term financing. It involves selling your receivables – the invoices you’ve sent to customers that are unpaid – to a lender so you can receive payment now, rather than waiting for customers to pay you. 

The lender takes on the risk and provides your business with cash in exchange for a fee. The goal here is improved cash flow, but you may end up paying more in the long run for this type of credit.

Working capital loan

Meant for the short term rather than long-term investment needs, these are used to finance the day-to-day operations of your business. This type of loan is typically linked to your personal credit, so be sure to stay current with your payments.

Small business term loan

Here you’ll get a lump sum of capital that you’ll pay back at a fixed interest rate over a specific period of time. In many cases, this type of loan is repaid in five years and used to fund a specific small business investment.

Equipment loan

This is a form of small business lending that helps you replace existing equipment or finance new equipment to help a business grow or diversify. A manufacturer, for example, might use an equipment loan to buy new machinery to expand its production capacity. 
Equipment loans typically require less documentation than other small business loans so the funding can be secured relatively quickly.

Small business credit card

This is similar to a personal credit card but may include additional reporting features that help the small business owner categorize purchases and track spending. It may also feature a rewards program to help you save money on regular purchases like office supplies.

SBA loan 

An SBA loan is a small business loan guaranteed by the U.S. Small Business Administration, which matches you with a lender that fits with your company’s size and needs. The guarantee means that if you can’t repay the loan, the SBA will pay out the guaranteed amount. Because of this guarantee, SBA loans can be tougher to get than other kinds of business loans, but they can be helpful to small business owners because they often come with benefits such as flexible down payment options, lower overheads requirements, longer terms and lower payment rates.

Business line of credit

This is an offering typically given by traditional banks. As with a credit card, you can borrow up to a certain limit and pay interest only on the amount you’ve borrowed. 

After opening a business line of credit, you’ll be able to draw funds and repay them as often as you’d like, as long as you don’t exceed your credit limit.

How to Qualify for a Small Business Loan

Qualifying for a business loan involves several important factors. By understanding your lenders’ minimum requirements, you can work to increase your chances of qualifying for a small business loan. Most lenders require borrowers to meet certain benchmarks, which may include a minimum credit score, annual revenue and years in business. 

Even though the money you’re borrowing for your business will not be used for personal expenses, potential lenders use your personal credit score as a measure of your creditworthiness. The higher your credit score, the less risky it is in the eyes of the lender to lend you money. A score of 700 or above is considered good, while a score of 800 or higher is excellent. Free copies of your credit reports can be obtained from the major reporting bureaus – Experian, TransUnion and Equifax. 

If you’re starting up a new business, getting a loan may be more challenging because many traditional lenders require you to be in business for at least two years. This is where non-traditional financing, like a short-term loan from an online lender, might be a viable alternative.

Some lenders will require you to provide collateral such as real estate, business inventory or equipment to secure the small business loan. If you’re concerned about losing assets or don’t have any, an unsecured loan might be an attractive option, but may come with less-attractive repayment terms, like a higher interest rate or fees.

The Small Business Loan Process

The process starts with being realistic about your business’s ability to obtain financing and the various types of loans for which you might qualify. According to the Forbes Advisor website, the process of obtaining a small business loan can be broken down into five steps:

1. Begin by deciding why you need the financing

Do you need money for expansion? For day-to-day operating expenses? To purchase new equipment or expand your shop? If so, one or more of the different loan types described earlier should suit your needs.

2. Determine if you qualify for a business loan

Different lenders have different minimum eligibility requirements and loan terms. Know your credit score and the impact it can have on your eligibility. How long have you been in business and how much revenue has your business generated over the last three years? Take some time to think about your finances and look carefully at your business’s income and cash flow to determine how much you can afford to apply to loan payments each month.

3. Compare business lending options

There are several places where you can find small business financing, including online lenders, traditional banks, credit unions and microlenders. Compare lenders by looking at their Annual Percentage Rate, or APR. APR is a good way to measure the total cost of a business loan because it includes calculations for all loan fees in addition to the interest rate. Other factors, like how quickly you can have the money, may also come into play with small business loans. 

If you lack collateral and time in business but need funding quickly, an online lender could be an option. If you’ve been in business for at least two years, have good credit and can wait longer to get the cash, a business loan from a traditional lender like a bank or credit union might be a better option. Traditional lenders typically offer term loans, lines of credit and commercial real estate loans at lower interest rates than online lenders. If you have bad credit, no credit history or are new in business, microlenders – nonprofits that typically make short-term loans of less than $50,000 – may be interested in working with you.

4. Gather all the required documents

You’ll need various legal and financial documents to complete your loan application. Typically, these may include:

  • Your driver’s license

  • A voided business check

  • Bank statements

  • Profit and loss statements

  • Business and personal tax returns

  • A business plan

Why include a business plan? It provides a buttoned-down prospectus of how you intend to use the money and how you believe it will help your business grow. The plan typically includes a business description, product or service description, market analysis, management team, sales and marketing strategy, implementation methods, financial plans and financial projections.

5. Submit your application

Once you’ve done your homework and submitted your application, you’ll have to wait for an approval. If your small business loan is approved, the lender will send you an agreement to sign before issuing you the funds or opening a business line of credit you can draw from.

FAQs

How much you should borrow with your business loan is up to you and your business’s needs. How much you can potentially be approved for can also be affected by several factors, including your business’s annual gross sales, existing debt and creditworthiness. What lenders are willing to lend out can also vary according to your business’s annual revenue. Your company should be cash flow positive after accounting for all debt payments.

Whether or not your able to get approved for a business loan will vary based on a number of factors. If you have a strong personal credit score and a profitable business that’s been operating for at least two years, lenders may consider you worthy of applying for the loan. Remember, this is just a place to start with no guarantee of approval.

A predatory lender is one that puts profits ahead of concerns about the borrower’s ability to repay the loan. When evaluating a potential lender, keep an eye on how they behave with you regarding the loan. Does the loan sound too good to be true? Are you being pressured to sign the loan agreement? Another sign can be extremely high interest rates on short-term loans. 

Credible lenders run a credit check on the borrower and ask them to verify their income to determine what monthly payments they can afford. Predatory lenders make their money with high interest rates, fees and are often less concerned with the borrower’s ability to repay the loan. 

A Google search for the lender should reveal any consumer complaints. Also check with the Consumer Financial Protection Bureau, an agency that implements and enforces federal consumer financial law and ensures that markets for consumer financial products are fair, transparent and competitive.

Understanding how small business lending works, the costs involved and what loan options will work best for your business takes time and research. Be sure to do your homework and don’t forget to compare the APR, which, mentioned earlier includes the interest rate and any associated fees. 

Borrowing for business needs like expansion, real estate acquisition, equipment or working capital can be a detailed process, but if broken down into a simple step-by-step process, it’s not as daunting as it may seem. Each lender will have their own process for potential borrows to follow. The five steps outlined earlier in this article are a good place to start in understanding what to expect from this process.

Conclusion

Obtaining small business financing begins with the borrower having a basic knowledge of the fundamentals of business management. The business owner should have the demonstrated ability to run a profitable business and put together a strong business plan to present to lenders. Small business owners should conduct extensive research to determine what types of business loans are appropriate for their needs and which loan type might be the best option for them. 

Develop Your Entrepreneurial Skills at DeVry

With courses that focus on customer relations, budgeting, forecasting, e-commerce and other small business topics, our Small Business Management and Entrepreneurship Specialization can be an excellent way to help you prepare to start your own venture or put other companies on a pathway to success. This specialization can be earned 100% online as part of any of our Bachelor’s Degree in Business Administration, our Bachelor’s Degree in Management or our Bachelor’s Degree in Technical Management. 

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