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How Do Small Business Loans Work?

10 min read • Aug 01, 2022 • Barry Eitel

The small business loan is a backbone financing product that has helped millions of small businesses get on their feet. How they work, and how you can apply for funding, though, requires some research. As with any financing, you should know the small business loans basics before filling out any applications.

You may have the false perception that only struggling businesses need to take on debt—actually, the opposite is closer to the truth. While loans can be used to help your business overcome challenges, they are best used for helping your company expand and, hopefully, become more profitable in the coming years.

What Is A Small Business Loan?

A small business loan is a debt-based agreement between a borrower, like an entrepreneur, and a financier, like a bank. In this agreement, the financier disburses funds to the borrower, which the borrower pays back over an agreed-upon period of time, with interest.

Typically, a financier bases approval for a small business loan on the applicant’s creditworthiness and how they plan to use the money for their business. While banks and credit unions are common commercial lenders, you can also apply for business loans from alternative financiers, many of which you can find online.

A small business loan is different from revolving lines of credit or business credit cards because you receive the amount of the loan upfront. With lines of credit, you receive funds to pay for expenses as they arise and you pay down your balance.

Types of Business Loans

With so many types of business loans, and the term “business loan” being so generic, it might be used to describe a wide range of financing products. Compare your options based on the amount of the loan, interest rates, and repayment periods. When it comes to more alternative forms of business financing, ensure you understand how the financing works and what you will be expected to pay.

Term Loan

A term loan is probably what comes to mind first when you think about a business loan. Usually offered by traditional lenders like banks or credit unions, a term loan is disbursed upfront. The borrower then repays the loan by fixed amounts every month, and pays any interest. Interest rates for term loans can be fixed or variable.

Generally, small business term loans are for large amounts (up to $2 million or more) and have repayment periods spanning several years, up to 10 or 25 years. Because of this, financiers usually have stricter thresholds for approval compared to some alternative forms of financing. In a sense, term loan lenders have an investment in the success of your business over the long term, so they will also want to see very detailed business plans and other documentation.

Startup Loan

As its name suggests, a startup loan is a form of financing made available to new businesses—that is, companies that have just started up. However, your business usually needs to have existed for at least 6 months to be eligible in many cases, so extremely new businesses won’t qualify.

Like other loans, you receive a disbursement of funds and use it as capital for the early days of your business. For example, the funds can be used for payroll, rent, inventory, or many other expenses. Startup loans are typically smaller than term loans, and they usually have higher interest rates and shorter repayment periods. However, the application process for startup loans is often less onerous than for term loans, which is important in the heady first few years of business.

Short-Term Loan

Business short-term loans function the same as short-term loans (sometimes called cash advance or payday loans) for individuals, except small business short-term loans are built for companies.

With these loans, you receive your money fast, and they have more relaxed requirements than term loans. Of course, you want to be responsible when applying for any debt, but short-term business loans serve a real purpose for many small companies.

Short-term loans come in amounts from $5,000 to $250,000 and carry short repayment terms of a few months to several years.

These types of loans can be extremely useful if your business hits a dangerous cash crunch or comes across an unexpected opportunity for profit. Getting your money fast is critical for digging yourself out of a hole or expanding rapidly to take advantage of changing conditions.

SBA Loans

The Small Business Administration partially guarantees some loans that are offered by lenders. The most popular SBA loan is called an SBA 7(a) loan, which can be used by businesses to finance real estate purchases, working capital, and business supplies. SBA 7(a) loans are also useful if you need to refinance existing debt.

Importantly, the SBA is a federal agency, not a bank itself. SBA loans are serviced by a private financier and are partially backed by the federal government via the SBA. Because of the government involvement, this type of loan has specific requirements all successful applicants must meet. 

Alternatives to Business Loans

Recently, due to online options, the range of small business financing has ballooned. There are many financing possibilities beyond the term loan, such as inventory financing and business cash advances. Many of these options get funds to your business within a few days, and many were created for entrepreneurs with poor credit in mind. Many loan alternatives, though, have mechanisms that work slightly differently than small business loans and carry higher interest rates, so do your research. Fortunately, Lendio has an easy-to-use free platform where you can compare options.

How Do Business Loans Work?

While there are different types of small business loans, your experience will probably follow similar steps:

1. Research and Gathering Documents

Before applying for any loan, you should thoroughly research your options and compare loan terms. With online platforms like Lendio, you can look at multiple options within minutes for free. You can also see what sort of documentation you need to prepare before applying. Especially for larger loans, like term loans, you should create a detailed and professional application packet.

2. Application and Financier Decision

After you know what business loan you want, fill out the application. In some cases, you might be interviewed in person by a representative of the lender. Once you submit an application, you must wait for an approval decision. This can take a few days to several weeks. If the lender deems your business creditworthy, you will be approved.

3. Disbursement

Typically, you will receive the total amount of the loan at once, either in the form of a check or funds deposited in your account. In many cases, you can use the money any way that makes sense for your business. On the other hand, you might have an agreement with your lender that you will use the funds for specific expenses, and you will need to honor that.

4. Repayment

Essentially, as soon as you get your loan disbursement, you will start making monthly repayments. You will have to pay the lender back for the total amount of the loan, as well as interest and any fees. You will usually make repayments until the loan “matures,” meaning you reach the end of the agreed-upon repayment period. This might be as short as a few months in the case of short-term loans, or it might be 30 years if you accept certain term loans. 

Skipping or refusing payments can lead to default and repossession. If you run into trouble with repaying your loan, you need to talk to the lender and determine a solution. If you sense your business could have trouble with repaying a loan, you need to have a conversation with your lender sooner rather than later.

Business Loan Requirements

In almost all cases, lenders will look at your personal credit score, how long your business has been open, and your business’ revenue. For term loans from traditional lenders like banks, you will probably need a credit score above 720. Additionally, your business will have to be at least 2 years old, and its annual revenue will usually have to top $100,000.

The requirements for other types of business loans, like short-term loans, are often less demanding. Usually you want to have a credit score of 600 or more. Also, your business typically has to have been in operation for a few months at least for approval. You will generally need to prove that your business earns several thousand dollars per month in revenue.

FAQs

What Do You Need to Apply for A Small Business Loan?

Before applying for any loans, write up a detailed business plan that discusses how outside funding will help your company. Almost all loan applications will require some documentation, so you should gather up relevant items like business bank statements, business tax returns, and your personal credit report. These documents provide a picture of your business’s financial history. As you research your loan options, you should note what sort of documentation is required for each lender’s application packet.

What Are Small Business Loans for Bad Credit?

For larger business loans with lower interest rates, you will usually be required to have a great credit score such as 700 or above. For some startup or short-term loans, you can apply with a score less than 700. If your score is between 550 and 680, you might not qualify for many business loan options, but there are likely alternative forms of financing that you could be eligible for.

A Small Business Loan Will Help Your Business Grow

It’s misguided to think of small business loans as reactive—in fact, many financiers will be more interested in applicants who plan to use funding as a route to growth instead of a way to get out of trouble. If you haven’t considered a small business loan yet, think about what your company could achieve with more capital. Maybe you could hire more talent, open a new location, or get that excellent new piece of equipment you’ve heard about. Small business loans can help your business expand over time, and Lendio can help you learn how easily and for free.

Disclaimer: The information provided in this blog post does not and is not intended to constitute business, legal, tax, or accounting advice. All information, content, and materials available in this post are for general, informational purposes only. For advice specific to their situation, readers should contact their attorney, business advisor, or tax advisor to obtain advice with respect to any particular matter.

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Barry Eitel

Barry Eitel has written about business and technology for eight years, including working as a staff writer for Intuit's Small Business Center and as the Business Editor for the Piedmont Post, a weekly newspaper covering the city of Piedmont, California.