What Is a Business Loan?
Starting a company can be expensive, which is exactly why business loans exist. A business loan is a way for business owners to borrow the capital (money) they need to scale their company with the agreement that they will pay this sum back according to the loan’s terms and conditions. The loan can be used as the business owner desires, however, this must be expressed to the loaner beforehand.
Business loans have basically been around forever and can be traced back 4,000 years to Mesopotamia where they were used by farmers. Obviously the loaning mechanisms have evolved and matured since, but it’s comforting to know that the farmers of 2,000 BCE could get their heads around this process — so you can too.
How Does a Business Loan Work?
Although it does vary slightly depending on the type of loan, generally business loans work in the following way:
- A lender will loan a set amount of money, known as the principal, to a business owner.
- The business owner will then pay back this same amount of money over time with interest (a percentage of the loan’s principal).
- This sum does not need to be returned right away and is usually paid back over a set amount of time with smaller payments.
See If You Qualify for a Kabbage Business Loan
Types of Business Loans and Lenders
There are six main types of business loans. Each has its own pros and cons, as well as recommended lenders:
Small Business Association (SBA) loans:
Government-backed loans ranging from around $5,000 to $5 million, which are actually provided by commercial banks or online lenders.
Lenders: Wells Fargo Bank, The Huntington National Bank, TD Bank, and JPMorgan Chase
Business term loans:
Based on your business’s credit score, these loans are usable for any purpose and require no collateral.
Lenders: Lendio, Kabbage
Business lines of credit:
These work like a credit card and are available to businesses with lower credit ratings.
Lenders: JPMorgan Chase, Bank of America, Wells Fargo OnDeck, StreetShares, and Headway Capital
Invoice factoring or financing:
You sell unpaid invoices for an advance between 60 and 90 percent. The company will then collect the invoice amount and you will receive the rest.
Lenders: BlueVine, Fundbox
This loan uses the equipment you purchase with it as collateral. It is available to companies with low credit scores and allows you to use the equipment even while the loan is being paid off.
Lenders: National Funding, Reliant Funding, Funding Circle, Crest Capital, and CIT Direct Capital
Merchant cash advance:
In exchange for a percentage of your business’s income over time, usually through credit card transactions, this loan provides a lump sum for small businesses.
Lenders: Fundbox, Can Capital, Lendio, National Business Capital, and Kabbage
Business loans for women:
There are also a number of business loans that are designed specifically for female entrepreneurs, offering unique benefits to women in business:
- Fintech company Kabbage offers small business loans — up to $250,000 — for women, which is supported by flexibility and guidance from experts.
- The Tory Burch Foundation has a Capital Program for women, providing “mentorship and networking, entrepreneurial education, and access to capital” between $500 and $100,000.
- Accion business loans for women-owned businesses is another great option for female entrepreneurs. Loans from this non-profit can reach up to $50,000.
- Grameen America is also a non-profit offering microloans to female entrepreneurs; starting at $1,500, the sum is intended to support training, networking, further education, and the opportunity for larger loans.
Learn more about the types of business loans and lenders.
Do I Need a Business Loan?
Before deciding to apply for a business loan, it is really important to stop and think about whether it’s necessary for your business. Many business owners can certainly benefit from this money if used effectively, however, it does require going into debt for your business — and that is a big decision to make.
There are a handful of key reasons why you would get a business loan, all ultimately revolving around the fact that you’re ready to take your business to the next level.
Maybe you want to upgrade the resources of your company, either through new equipment, inventory, or through an expanded physical location. If you are in need of a bigger office, warehouse, more inventory, or a new forklift, that is a good sign that the demand is there for your product; that business is booming. Before making a decision, be sure to calculate how these costs will affect your profit.
Aside from physically expanding your operations, another good reason to get a business loan could be to build more credit for the future. Taking out a small loan can help companies qualify for more substantial future financing, which can be a smart move.
These are just a few of the reasons why a business-owner should consider a loan, but in reality there are many more scenarios in which loans can be beneficial.
How Do I Qualify and Apply for a Business Loan?
1. Determine how much money you need
There is a widespread belief that “you can never ask for too much money when getting a business loan.” But this can be dangerous — a lender will see your requested amount as a reflection of what you believe to be your business’s financials and growth potential. That’s why it’s important to calculate, ahead of time, how much money you really need.
Don’t high or low ball because it will leave you with regrets. Ultimately, balance out what you need and what you think is possible for your business using realistic future projections.
2. Choose what type of loan is best for your business
When choosing a loan for your business, you need to ask yourself a few questions to make sure you’re finding the perfect fit:
- How much money do you need?
- How much does it cost (a.k.a what’s the interest rate)?
- How long do you have to pay it back?
- How soon do you need the capital?
- Why do you need the loan?
NerdWallet has a quick summary of the key benefits of each type:
- A term loan is best for long-term growth
- An SBA loan has a low interest rate
- A line of credit is best for short-term expenses
- Invoice financing is good for keeping a cash flow steady
- Business credit cards are flexible and offer rewards;
- Personal loans are pricier, but useful as a source of startup funding
- Merchant cash advances have high borrowing costs
- Microloans are perfect for smaller funding demands.
You should use a bank if you can provide collateral, have good credit, or don’t need the capital quickly.
3. Find out if you qualify
After you’ve figured out what you need the loan for, you need to check if your business qualifies. To qualify, your credit score needs to be above a certain number. Many of the least expensive lenders want credit scores at least above 680.
Then there is the question of how long you’ve been in business. For most small-business loans, you need to have been in business for at least one year; for banks, at least two years.
The amount of money your company makes is another important factor. Most popular lenders require a minimum annual revenue of around $50,000 to $150,000.
Finally, lenders need to know that you have the cash flow to make the agreed payments.
4. Organize your paperwork
Now, you are ready to organize your paperwork for your application. The documents you’ll need depend on the loan you’re applying for, but generally applications require:
- Business and personal tax returns
- Business and personal bank statement
- Business financial statements
- Business legal documents
See If You Qualify for a Kabbage Business Loan
How to Use Your Business Loan Effectively
Now that you have your loan, you need to plan out the best way to spend the money. But before that, make sure you have budgeted for your repayments. There are ways you can make this process easier.
The first is completing an honest assessment of your company’s finances and creating a careful budget, so you can “figure out your working capital needs and make sure that you aren’t spending your loan outside of the business’s means.”
Also, manage your cash flow and minimize expenditure on non-critical purchases. You can get ahead by keeping your business and personal finances separate, and paying more during the busy season. It’s important to keep your credit score strong throughout and know when you need to refinance.
Spending your loan effectively really depends on what you needed the loan for in the first place. But some good uses of the money include investing in inventory or equipment, or other large purchases that have a high up-front cost and large long-term payoffs. Marketing could also be worthy of the funds, as it is almost always beneficial to attract new customers. Hiring and training, new websites, and technology have also proven to have high return on investments.