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What is Small Business Loan? How does it Works?

Small business loan, Whether you’ve developed a product, thought of a unique solution to a common problem, or simply love the idea of being your own boss, there are plenty of reasons you may want to own a small business.

If you choose to pursue business ownership, you’ll quickly learn that it takes quite a bit of money, especially upfront, to get it up and running. A small business loan can provide you with the cash your venture needs to succeed.

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What Is a Small Business Loan?

Small business loans are types of financing provided to companies for different purposes by various lenders. Over time, several types of small business loans have evolved to help entrepreneurs meet their goals. Therefore, the way a small business loan works depends on the type of loan in question.

Importance of a business loan

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Business loans have long been a viable way to keep operations going. They are used by business owners for many reasons, such as a short-term boost to cash flow or to cover the cost of pricey equipment.  Business loans can also be used to pursue growth and to consolidate high interest debt. There are a lot of benefits of going taking funding route, including the following:

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  • You keep full control of your business. When you take out a business loan your bank or alternative lender isn’t going to tell you had to use the funds. That’s not true when you have investors providing capital. They usually want a say in how the business is run. Bank loans do come with interest and fees, but you aren’t giving up a stake in your business, a piece of the profits, and control in operations.
  • Funding is fast. Raising capital via venture capitalists or other investors can take as long as 12 months. Borrowing money from a bank, credit union or online Len
  • der is much faster and when you apply online, some lenders can approve your application in minutes.
  • Interest rates are lower for loans than credit cards. When it comes to credit cards and business loans, the latter tends to win out in terms of the cost to borrow. For business owners with the best credit scores, business loan interest rates range from 2% to 13% according to Experian. For business credit cards that rate range is 13.9% and up. Keep in mind your credit score plays a big role in the cost to borrow and if you’ll get approved for a loan.
  • Down payment – A sum of money the borrower must pay towards the project – represents a percentage of the project costs.
  • Loan terms – The specific conditions involved when borrowing money, including the interest rate and the repayment period.

Related: What is Business Loan? Definition and Types

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  • Working capital – A type of small business loan that can be used to fund every day, operational needs.
  • Financial covenants – Agreement between borrower and lender with certain restrictions for the borrower while paying on the loan.
  • Personal guarantees – The borrower agrees, in conjunction with the business, to be 100% personally responsible for repaying the loan in full.
  • Choosing the right lender – Our general guidance on how to select a lender.

Types of lenders

Small Business Administration loans

  • The Small Business Administration offers several loan programs designed to meet the financing needs of a range of business types.
  • With these loans, the government isn’t directly lending small businesses money. Instead, the SBA sets guidelines for loans made by its partners, which include banks, community development organizations and microlending institutions.
  • The SBA reduces the risk to lenders by guaranteeing the loans will be repaid.
  • Businesses have a variety of SBA loan types to choose from, each of which comes with its own parameters and stipulations on how the money can be used and when it must be repaid.

Pros and cons:

The government guarantee, which typically covers 75% to 90% of the loan, eliminates much of the risk for the lender. SBA loan terms also tend to be more favorable to borrowers. The downsides are that additional paperwork needs to be filed, extra fees need to be paid, and it takes longer to get approved. You may also have to meet stricter requirements to qualify for a loan from a traditional SBA lender.

To learn more about specific SBA loans, review the SBA loans portion of the Types of Loans section below.

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Conventional bank loans

Pros and Cons: The biggest pluses of conventional bank loans are that they carry low interest rates and, because a federal agency is not involved, the approval process can be faster. However, these types of loans typically include shorter repayment times than SBA loans and often include balloon payments.

Additionally, it’s often difficult to get approved for a conventional bank loan. Traditional banks approved only 23% of funding requests in March of 2016, which was considered a new high. Compared to the near 61% approval rating of alternative lenders in the same timeframe, it still seems low.

Alternative lenders

  • Alternative lenders are particularly attractive to small businesses that don’t have a stellar financial history, because approval requirements aren’t as stringent.
  • Alternative lenders typically offer online applications, make approval decisions in a matter of hours and provide funding in less than five days.
  • There are direct alternative lenders that lend money directly to small businesses and lending marketplaces, which provide small businesses with multiple loan options from different direct lenders.
  • Examples of direct alternative lenders are Kabbage, OnDeck, and SBG Funding. Lending marketplaces include Bizfi and Biz2Credit.

Pros and cons: The positives of working with an alternative lender are that your business doesn’t need to have a stellar financial history; there are few restrictions on what you can use the money for, and the loans can be approved almost instantly. The downside is that interest rates can be significantly higher than those charged by a bank. Because of the nature of the loan, it’s important to pore over the fine print and ensure you’re entering into an agreement that makes sense financially for your business.

Small Business Line of Credit

A small business line of credit is similar to a credit card. You can borrow up to a certain limit and only pay interest on the amount of money you borrow. If you take out a small 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 go over your credit limit.

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Accounts Receivable Financing

Also known as factoring, accounts receivable financing involves selling your receivables or outstanding invoices to a lender so you can receive early payment for them. The lender takes the risk on your receivables and provides your business with some cash in exchange for a fee. Age and quality of the receivables will play a role in the amount of money you’ll receive. While quick access to cash is an advantage of accounts receivable financing, you’re likely to pay more for this type of financing than others, especially if your business credit is less than stellar.

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Working Capital Loans

Unlike some small business loans intended to pay for long-term assets or investments, working capital loans are used to finance the everyday operations of your business. These operations can include things like rent, payroll and debt payments. Compared with other small business loans, working capital loans feature shorter terms and lower amounts. These loans are sometimes linked to your personal credit, which could take a hit if you don’t make your payments on time.

Small Business Term Loans

If you take out a small business term loan, you’ll get a lump sum of capital that you’ll pay back at a fixed interest rate with regular repayment terms. In most cases, these types of loans are repaid in five years and used to fund a specific investment for a small business.

Just like mortgages and car loans, small business term loans usually follow an amortization schedule, meaning most of your payment will go toward your interest at the beginning.

Where to Get a Small Business Loan

The Average Small Business Loan in 2020 was $71,072 - Small Business Trends

There are several different places you can go to for a small business loan, including:

Direct Online Lenders

There are many online lenders that offer loans directly to small business owners. Since they use the power of technology and algorithms, their loans are quicker to obtain than the loans of traditional lenders like banks.

However, the costs of borrowing with direct online lenders is typically higher. You may want to pursue this route if you need access to quick cash and are having trouble qualifying for a loan from a traditional lender.

Large Commercial Banks

While large commercial banks have rigorous requirements for small business loan borrowers, they have the power to offer larger loans than other lenders, which can be very helpful when you’re growing your business.

Related: What is Business Loan? Definition and Types

Another advantage of taking out a small business loan from a large commercial bank is the chance to lock in low interest rates. Keep in mind that while financing with a commercial bank has its pros, these loans can be challenging to qualify for, especially if you don’t have the best credit.

Large Community Banks

Community banks are locally owned and operated. Because they are typically smaller than commercial banks, they can provide you with more individualized service, which can be a huge plus as your business grows.

In addition, unlike commercial banks, which may solely focus on your credit score and financial statements, community banks are more likely to look at your entire credit report and other aspects of your business. This is a huge advantage if you have a solid credit history but don’t have the best credit score.

Peer-to-Peer Lending Sites

Small business loans from peer-to-peer lending sites such as Prosper and Lending Club are often easier to qualify for than loans from traditional lenders because the money comes from a group of investors instead of a single lender. These types of loans usually come with higher interest rates that can increase the overall cost of your loan.

Here’s how peer-to-peer lending sites work: The P2P lending site acts as the middleman between you (the borrower) and the investors. It can match your loan request with investors’ funds. Investors that lend to you will receive the interest you pay on the loan minus the lending site’s fee.

Bank Lenders Backed by the SBA

Many SBA preferred lenders are banks that have strict requirements for applicants.

Although SBA loans are difficult to qualify for, they are definitely worth considering, as they come with lower down payment requirements, lower interest rates and longer repayment terms than other options.

How to Qualify for a Small Business Loan

The process of qualifying for a small business loan involves several steps that we’ll outline below.

Build Your Personal and Business Credit Scores

Lenders that offer small business loans will take a look at your personal credit score to help them determine whether they should lend you money. Your personal credit shows your ability to repay your personal debts like your mortgage, car loans and credit cards. The higher it is, the less risky you are in a lender’s eyes and more likely you are to get approved for a loan.

So, what constitutes a good credit score? While a score of 700 or above is considered good, a score of 800 or above is known as excellent. To find out where your credit score stands, visit AnnualCreditReport.com and obtain free copies of your reports from Experian, TransUnion and Equifax. You can also get a free credit report from Experian every 30 days.

If your credit score is lower than you’d like it to be, pay your bills on time, pay off debt and keep balances low on credit cards and other revolving credit. Also, refrain from applying for too much credit, as doing so can create multiple hard inquiries in your credit file and have a negative impact on your score.

Once you’ve built your personal credit, it’ll be time to focus on your business credit score. To begin establishing business credit, incorporate or form an LLC, obtain a federal Employer Identification Number (EIN), and open business accounts in your business name.

Know the Requirements

By understanding a lender’s minimum requirements and qualifications, you can increase your chances of getting approved for a small business loan. While some lenders may be flexible, most of them require that borrowers meet a minimum credit score, annual revenue and years in business.

Out of all the types of business loans available, loans from banks and those that are backed by the SBA are the most difficult to qualify for. While the minimum credit score for these types of loans is typically 640, a higher score in the 700s or 800s is preferred.

When it comes to small business loans from direct online lenders and peer-to-peer lending sites, requirements are less stringent. You may be able to get approved with an average or above average credit score in the low to mid 600s.

In addition to meeting credit score requirements, you’ll need various legal and financial documents to complete the application paperwork. These documents will likely include things like your driver’s license, a voided business check, bank statements, profit and loss statements, business and personal tax returns, and a business plan.

 

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