Congrats! If you are reading this, you have a small business or are considering starting one. In either scenario, there may come a point when you need to borrow money in the form of a small-business loan. You have come to the right place to examine your options. In this guide, we’ll explore how small-business loans work and when they are (or aren’t) good choices for funding a business.
There are various ways you can fund a company that needs capital: Self-fund, take out a small-business loan (or use business credit cards — a risky proposition), crowdfunding, invoice financing, line of credit, microfinancing, relying on angel or venture capital, or securing a loan through the Small Business Administration (SBA).
For this ultimate guide, we will go into the pros and cons of obtaining a small-business loan to help you understand your options.
Obviously, your long-term business plan should be to become cash-flow positive as soon as you can. No business can survive if it can’t make enough money to stay afloat. All of the above options are powerful financing tools along with an actionable and viable business plan.
That said, a small-business loan can make a positive impact on your business under certain circumstances. Perhaps you need to buy more inventory, expand, scale your offerings to remain competitive, or to keep your first-mover advantage. Whatever the case, many businesses use loans at some point in their growth.
Things to consider are how soon you need the loan, for what do you need it, and how long will you need to repay the money? Once you have an idea of these factors, there are additional variables to consider.
What Is a Small-Business Loan?
A small-business loan is a sum of money lent to you (the borrower) by a traditional bank or credit union, the SBA, or an online lender. (As a result of online lending, there are many more available funding options than before.)
In return, the lender requires that the borrowed money be repaid over a predetermined period of time and at a certain interest rate. That’s it. Before considering a loan, there are some common terms you should be familiar with or may already know:
Borrower: The person or entity that intends to borrow a sum of money and agrees to repay it over a period of time with interest accrued.
Lender: A person, organization, investor, bank, or other entity that lends money to the borrower and expects the loan to be repaid over time with interest.
Interest: The amount of money, almost always expressed as a percentage, that will accrue daily, monthly, or annually for the duration of the loan. As a simple example, if you borrow $100 at an annualized percentage rate (APR) of 10 percent , you would owe $110 after one year if you haven’t repaid the loan. The $100 is called the principal and the $10 is called interest.
Repayment Term: The agreed upon time to repay your loan. Some loans are paid back all at once, but most often there is a repayment schedule you follow.
Of course, all loans have their terms, so you should carefully consider why you are taking out a loan, and weigh the pros and cons of any offers to lend you money. There is no such thing as free money, so any lender will look at the health of your business before deciding how much to lend you and on what terms.
In addition to reading the fine print, ensure you are dealing with a reputable company, organization, or individual lender.
How Do You Qualify for a Small-Business Loan?
Most small-business loans are meant for companies that have been in business for at least one year and have revenue. If you are a start-up, you will want to consider alternative funding options such as crowdfunding, friends and family or an angel round. If you do have a bit of business history and revenue, there are several types of loans to consider.
Just like with a person seeking a loan, a business goes through a similar evaluation. Some of these factors include:
Creditworthiness: Unlike personal credit, a business credit score is measured on a scale of 1 to 100 with 75 considered excellent. The three bureaus that measure business credit scores are Dun & Bradstreet, Experian, and Equifax. It’s smart to establish some sort of credit history by paying bills on time or using a business credit card.
That said, you will see personal credit score numbers often listed to determine if you qualify for a business loan. Having a personal credit score of 650 can help you secure a loan. Just ensure you understand the terms of the loan and what credit score the lender is using to determine the terms of your loan and why.
Legal, Financial, and Tax Documents: Be sure that your company has a business registration or employer identification number as appropriate.
Well-Prepped Business Plan: Any entity that is considering lending you money wants to make sure you have a solid business plan. You’ll need to show your lender your past financial performance and future goals.
Revenue/Collateral: It often seems like a catch-22 — you need money to make money. Lenders will want to know what revenue you have, or other collateral you own. That way, if you default on your loan, your creditor will be able to recoup losses.
Remember that the more risk the lender assumes (due to your low credit score, low revenue, less time in business, etc.) the more likely the lender will want to mitigate exposure by charging a higher interest rate.
Are Small-Business Loans Hard to Get?
They can be. To increase your likelihood of qualifying, here are some items you’ll want to have in order.
Include your business plan, which should go into organized detail about your financial targets, current revenue, overhead, target market, cash flow, and debt. Know your numbers inside and out, or have a trusted person help you with your narration if this is not your forte.
If you have a financial track record of a year or more, be ready to show your federal tax return, accounts payable and receivable, and any business assets and liabilities .
All in all, keep in mind that any lender’s primary concern is your ability to repay the loan, so anything you can do to underscore your repayment ability will increase your odds of success.
A number of online lending solutions now exist that help small-business owners with a faster and sometimes less stringent approval. On one hand, this can be great if you are in a cash crunch, but beware of the interest rates you may be charged for the convenience.
What Are the Best Small-Business Loans?
There isn’t a “best” small-business loan, but there are different types of small-business loans to consider. The “best” one is the one for which you can qualify that fits your needs. Here are the sources of small-business loans common types of small-business loans:
- The SBA Loan — backed by the government — will provide you $500 to $5.5 million. SBA loans can be used for fixed assets and operating capital, but your business will need to meet certain criteria: The company must meet a threshold for the number of employees and revenue, must be U.S.-based, must be a for-profit business in which the founders own equity, and must agree not to take funding from another lender. Note that the SBA does not lend directly to businesses, but you can easily find an institution that handles SBA loans here.
In addition, the SBA has several programs for entrepreneurs who meet certain criteria. The 8 (A) business development program helps businesses that are owned at least 51 percent by socially and economically disadvantaged individuals.
Likewise, there are programs for women-owned small businesses (again owned at least 51 percent by women) and historically underutilized business zones, or HUBZones set aside for small businesses in economically depressed communities.
- Your local bank, credit union, or an investor is considered a direct lender. Banks can have some of the strictest application requirements, but they also tend to have lower interest rates. Also, all three may be able to help you in other aspects of your business.
- P2P lending — or peer-to-peer lending — has become more popular over the past decade. Traditional banks and credit unions have an arduous process for loan approval, stringent standards, and take more time than their online counterparts. Some online lenders offer loans within minutes, many within days. Similar to traditional financing, these P2P lenders offer similar services: lines of credit, equipment and finance leasing, and invoice financing (where the lender gives you money earlier than your vendor pays its invoice to you). These loans range from several thousand dollars to several million. These lenders have disrupted the lending industry with the ease, speed, and transparency they offer.
The current round of PPP loan applications opened in early January 2021. Find out more about what the CARES Act means for small businesses here.
What Is the Difference Between a Secured and an Unsecured Business Loan?
It’s super important to know the difference between the two and what you are being offered as a borrower. You should ask any lender you work with which they offer.
In a nutshell, an unsecured loan is based on a company’s credit history, the health of your business, your credit rating, and your reputation when calculating the risk of loaning you money.
A secured loan means that you will need to offer collateral in addition to repayment. Forms of collateral could be anything from inventory and equipment to your property/home. The distinction is important to understand because if your company defaults — or is unable to repay — the loan, the lender can have your collateral appraised and taken to repay your debt.
What Are Other Types of Business Financing?
- Line of credit: A line of credit is essentially a short-term small-business loan. This option is attractive to business owners who have the need for short-term working capital or seasonal costs. It’s also a nice cushion to know your business has a line of credit at its disposal in case of an expected expense. The other advantage of a line of credit is you pay interest only on the money you borrow. If you have a $10,000 line of credit, and you borrow $2,000, you pay interest on the $2,000 until you repay it. Unlike a loan, your line of credit can be reused as needed whereas a loan ends once it is fully paid off.
- Microloans: Typically granted by nonprofits for mission- or cause-based businesses, microloans are a resource worth considering if they are a fit for your business model. Business owners may also receive additional training. The Aspen Institute Business Ownership Initiative includes a microloan tracker of more than 70 U.S. microloan entities updated to reflect the most recent data in 2018. It’s a good place to start your research. The SBA also oversees a microloan program, which specifically helps women, low-income, veteran, and minority entrepreneurs, and other small businesses in need of small amounts of financial assistance. Under the microloan program, the SBA makes direct loans to intermediaries that, in turn, use the proceeds to make small loans to eligible borrowers. These loans are for up to six years and up to $50,000.
- Community Investment Funds: Community investment funds increase access to financial services in low-income and underserved communities. The National Community Investment Fund has a directory of an organization near you. Similar to microloans, community investment funds are philanthropic and mission-driven in nature, to help businesses grow where they would otherwise not be eligible for traditional financing.
- Invoice financing or factoring: Any business owner has likely been in the position of having to make payroll while their vendors are taking their sweet time to pay what’s due. To help with this pain point, invoice financing helps businesses borrow money against unpaid customer invoices. For example, some companies may pay you every 60 days, but your company may find itself in a situation where it needs some of that outstanding money owed sooner. Typically, invoice financing can be structured in several ways, most often as invoice factoring or discounting. With invoice factoring, XYZ company sells its outstanding invoices to a lender. The lender will give XYZ Co. about 70–85 percent of the cash it is owed for the total amount due. Once the lender is paid, the business will receive the remainder of money minus fees and interest from the lender. Invoice discounting may be preferable, if possible. In this scenario, the lender provides XYZ Co. with 90–95 percent of the value of the outstanding invoices directly. XYZ collects the money itself — no middleman — so the vendors aren’t aware that a bank is involved in the transaction. As clients pay their invoices, XYZ Co. pays the lender, minus fees and/or interest.
- Equipment loans: Most businesses use some sort of equipment — computers, desks and chairs, a dentist chair, a delivery van, etc. Depending on the type of equipment, you may want to own it. The general rule is something that doesn’t depreciate (lose) value quickly is something a company will often buy. Equipment loans can be an attractive alternative to equipment leasing. To weigh the costs and benefits you should consult your accountant.
- Merchant cash advance: This option is an advance on your credit card sales. There may be situations in which your business needs money immediately, and this option makes sense, but make sure you know what you will pay for the convenience of getting cash quickly. The lender will take a holdback amount, typically 10–20 percent of your daily credit card sales until the advance is completely repaid.
- Small-Business Credit Cards: After you have been in business for a year or more, you will likely start to receive offers for business credit cards. Used responsibly, they can be a source of cash, and can help you build credit. Using them as a loan is not a winning strategy because credit card interest rates are higher than what you would normally find with a small-business loan or other types of small-business funding.
Can I Get a Business Loan With Bad Credit?
Yes, it is possible to get a business loan with either bad personal or business credit. Most lenders want to see a personal credit score of at least 500. Just be aware that the lower your credit score, the higher the APR on the loan. And this makes sense, because if you have bankruptcies or a shady credit history, your lender is assuming more risk. That risk means you will pay more for the loan.
For example, if your personal credit is lurking around 500, some companies will lend you money with an interest rate ranging from 24.99 to 99 percent. Ouch.
Another option is to take steps to improve your business and personal credit, so you can get better terms on a small-business loan. It may mean you move more slowly. If you can increase your revenue, pay your bills on time or even early, and build a more positive financial history, the more likely a lender will treat you favorably.
What Fees Are Common and What Should I Avoid?
It’s good to have a handle on some fees that are standard and those that are not, so you aren’t played by a shady lender.
Fees that are common:
- Origination fee is charged for processing a loan.
- Underwriting fee is charged for the cost the lender accrues reviewing your documentation for the loan (your business plan, financial documents, credit reports, etc.)
- Closing costs
- Fees associated with servicing the loan (this might be an appraisal of your business)
- APR, Interest: These charges are common to any small-business loan.
- Prepayment penalties: Some loans, regardless of the type, will have a prepayment penalty to mitigate the lost income to the lender who would have continued to charge you interest.
How Can I Tell If a Small-Business Loan Is a Scam?
First, use your common sense. If something seems too good to be true, it likely is, especially where money is concerned.
Do your research to ensure you not only understand all your lending options, but read the fine print of any loan document before you sign it.
Ask questions and don’t work with anyone who tries to rush you into a decision.
The Federal Trade Commission (FTC) offers some guidelines to avoid loan scams. A popular one is the advance-fee loan, where you are asked to pay money upfront before you are given a loan.
While legitimate lenders also charge fees (listed above), they disclose their fees prominently, discuss them with you, and take the fees from the amount you borrow, after your loan is approved.
It’s illegal to be offered a loan over the phone that requires an upfront payment or deposit, according to the FTC. Keep this in mind if you’re ever on the phone with a prospective lender and they ask for a good faith deposit in advance.
Beware of copycat names. Cases have been reported where scammers have used fake government, big banks, or other recognizable names to dupe consumers.
Starting a business or being a seasoned entrepreneur is challenging — and exciting, yes — but ensure you take your time to research, talk to those you trust and make smart choices. We are here to help.