How Do Small Business Loans Work?

Written By Scott Kessman
Last updated July 16, 2021

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Loans
July 16, 2021

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A small business loan can be a major benefit to a business that has just opened or is experiencing growth. Small business loans are also ideal for businesses that need to make a large investment in equipment. But before you seek a small business loan for additional financing, you should know what type of business loan is right for your needs. There are also several options for where to apply for a small business loan.

Without prior experience getting a business loan, you might not be aware that there are several different types to choose from. They were each designed for specific needs to better help small businesses achieve their goals in the best financial way possible.

Small Business Term Loans

When you get a small business term loan, you essentially borrow a sum of capital. The loan is paid back over a specific term period at a fixed interest rate. A typical term length for a small business term loan is five years. Like a mortgage, the bulk of the payments at the beginning of the term will be comprised of interest.

SBA Small Business Loans

Many businesses also seek a loan from the U.S. Small Business Administration. The SBA is a federal agency that works with entrepreneurs on many aspects of growing a business. The loans granted by the SBA actually come from different lenders but are guaranteed by the SBA. This means is that if you have trouble paying back your loan, the SBA will pay it out to the lender.

For loans of up to $150,000, the SBA will guarantee 85% of the loan. For loans larger than that, the SBA will guarantee 75%. Getting an SBA loan isn’t easy. Businesses must supply the SBA with a large amount of paperwork and meet strict criteria to be approved.

Small Business Line of Credit

Sometimes businesses need access to large sums of capital but don’t necessarily want to take out a large loan. How do small business loans work in this situation? A common solution is to seek a small business line of credit. This is similar to a credit card. With a line of credit up to a certain balance, you can borrow what you need, when you need it. Payments are made at a fixed interest rate. A line of credit can be used as long as you make your monthly payments and don’t go over your credit limit.

Working Capital Loans

New businesses may not have accrued a large amount of profit yet, but still need to pay bills and employees. Working capital loans can be used to finance everyday operations and expenses such as rent or payroll. This type of loan can also come in handy if you have a seasonal business. For periods of time when you don’t make as much a working capital loan can really help. Working capital loans are typically for smaller amounts than other small business loans and have shorter terms.

Equipment Loans

If you simply need extra cash to purchase new equipment, you can seek an equipment loan. How do small business loans work for equipment purchases? For starters, these are easier and quicker to get than other loans. However, you need to show proof that you are using the money for equipment.

Now that you know a bit more about how small business loans work, the next step is to decide where to get one.

Banks

In the past, it was commonplace for small business owners to go to their local bank to seek a small business loan. But over the years, the banks have made it increasingly difficult for new businesses to get a loan. The main advantage of getting a loan from a large bank is that they offer much larger loans than other lenders.

Online Lenders

Today there is a large availability of online lenders. It can be easier and quicker to obtain a loan through an online lender, but their rates are usually higher.

Lenders Backed by the SBA

As mentioned above, the SBA can help you to secure a small business loan. Although the requirements for approval will be strict, the loans have lower rates and longer repayment terms.

As with most loans, your personal credit score will be an important factor. Smaller banks and lenders will definitely take your personal credit score into consideration. A good credit score shows your ability and history in repaying other debts and loans.

Build Your Personal and Business Credit Scores

Lenders that offer small business loans will take a look at your personal credit score. 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. This makes it more likely that you will get approved for a loan.

But this isn’t the only credit score you need to be concerned about. You’ll also need to have a good business credit score as well. In order to establish and build up your business credit score, you’ll have to open a few business accounts.

You must meet other requirements that will vary according to the lender and the type of small business loan you are seeking. Some lenders will require you to have a minimum annual revenue. Others will want you to have been in business for a minimum number of years. Knowing the requirements of each lender saves you from wasting your time with particular lenders.

Typically, for small business loans from online lenders, the minimum credit score required will be in the low to mid 600s. The requirements for loans backed by the SBA are higher. The minimum is 640, but a score above 700 is preferred.

There will also be a multitude of paperwork you’ll need to fill out and supply for most small business loans. These include a business plan, bank statements, profit and loss statements, and business and personal tax returns.

The Business Plan Requirement

When you get a mortgage, it’s obvious the loan is for the purpose of purchasing a home. When you get a personal loan, lenders aren’t too concerned with how the money is used. They just want to make sure you meet the requirements for the loan. But how small business loans work is different. Lenders want to know exactly what you are going to use the money for and why you need the amount you are requesting.

That’s the purpose of creating a small business plan. It is a lengthy, detailed document that showcases what you need the loan for. There are a number of different components to a business plan, but it will usually need to include the following:

A description of your business

  • A description of your products and services
  • Market research and analysis
  • Information about your management team
  • Sales and marketing strategies
  • Your financial plan
  • Future sales projections
  • Details on how the loan will aid your business in growing and becoming more profitable

Now that you are better aware of how small business loans work, research your options. Prepare to meet the requirements of the lenders to improve your chances of getting approved.

About the Author

Scott Kessman

I possess a strong 20-year background in marketing, digital marketing, and advertising. However, writing has always been a true passion of mine, and after working in corporate offices for many years, I turned my passion for writing into a full-time job. As a contract content writer for the last 12 years, I can craft engaging and informative content about a wide variety of subjects. I have also written and published two fantasy novels and a collection of short stories.

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