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On the hunt for a small business loan but don't know where to start? Check out our full guide to understand your financing options.
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How do business loans work?
Small business owners should be able to answer this question before seeking commercial financing— you certainly don’t want to take out a loan without understanding the terms! To help you understand the basics of business loans, we have put together all the important details on how small business loans work in one place.
Read on to learn everything you need to know about small business loans and how they work.
Table of Contents
A business loan is a type of financing businesses can use to pay for various expenses, like inventory, equipment, payroll, expansion, and more. A business loan cannot be used for personal expenses such as personal vehicles or any other expenses unrelated to the business.
Business loans are typically disbursed as a lump sum of cash that the loan recipient repays over time in installments for the duration of the loan’s term. The term could range anywhere from 3 months to 30 years, and the installment schedule may be daily, weekly, or monthly. In addition to the amount you borrow, you will also pay the lender interest and/or other fees.
Typically, the business loan process is as follows:
With a business term loan, also known as an installment loan, you receive a set amount of money at the start of the term, and repay it in installments until the term ends. Another type of business financing is a line of credit. With a revolving LOC, businesses can draw funds as needed, and the line is replenished as repayments are made.
There are a number of reasons small business owners seek out a business loan:
Note that while some business loans can be used for any business purpose, other loans have specific purposes, such as loans for equipment financing or SBA commercial construction loans.
There are many various types of small business loans and they all work a little differently.
Different loan products are suitable for different uses. Products with short-term lengths, such as short-term loans, invoice financing, and lines of credit, are normally better for working capital needs. Longer-term products, such as medium- or long-term loans, are better for business expansion or refinancing purposes.
Many banks and credit unions offer business loans and lines of credit to eligible merchants. Bank loans are traditional term loans, also called installment loans, that you pay off in over a period of years (rather than months, as with many online loans). To qualify, you’ll generally need to have good credit and at least two years in business. Most banks have very long and detailed applications, but they’re worth it to get the lowest interest rates and longest term lengths.
The Small Business Administration (SBA) is a good resource for merchants who can’t qualify for a bank loan on their own. Rather than issuing loans, the SBA backs a portion of your loan, so your business isn’t as risky and matches you with one of their partner lending institutions.
To qualify for an SBA loan, you’ll still usually need at least two years in business, assets you can use as collateral and fair credit.
Medium-term loans are installment loans that range from about three to five years in length. These loans are normally offered by online lenders.
Because the term lengths are shorter (and therefore less of a risk), medium-term loans are normally easier to obtain than bank loans. But you still have to have an established business (at least a year or two old) to qualify.
Short-term loans (STL) are online loans with terms ranging from three months to two years. Often, these loans carry a one-time flat fee instead of an interest rate, which means you’ll know the total cost of the loan before borrowing. Repayments are made in daily or weekly installments. STLs can be expensive, but they are easy to apply for and can be a life-saver if you need cash immediately—depending on the lender, you can receive your loan in as little as one business day.
Technically, merchant cash advances (MCA) are not loans—they’re sales of future receivables. These “purchases” are collected by deducting a portion of your sales each day. Although they have no set term lengths, most MCAs are structured to be repaid over the course of three months to two years. MCA borrowing rates tend to be even higher than those for STLs, though they are very fast and easy to qualify for.
Lines of credit (LOC) function similarly to credit cards—you are given access to a certain amount of money, you can draw up to your limit whenever you want, and you only have to pay interest on the amount you’ve borrowed. This type of financing is excellent for businesses that frequently need to borrow small amounts of capital.
Many LOCs are revolving, which, again, means that your line is replenished as you repay funds you’ve borrowed.
Lines of credit are offered by many lenders—both online and through banks. Term length for LOCs varies, but generally online lenders offer shorter-term lines of credit, whereas banks offer longer terms on their LOCs.
Merchants in the earliest stage of starting a business often don’t have access to a whole lot of capital. If you’re unable to continue bootstrapping and/or have exhausted the bank of family-and-friends, you could consider getting a personal loan for business.
Because personal loans are based on your individual creditworthiness, not that of your business, these loans are attainable, even if you don’t yet have enough profits or time in business. Keep in mind that these are generally small loans, typically maxing out at $35-$50K.
Equipment financing is exactly what it sounds like: a loan to finance business equipment. Your lender fronts you the money to purchase the equipment, and you pay it off in installments until you own the equipment outright. This type of loan typically doesn’t require any business collateral or even good credit, as the equipment itself serves as the collateral.
Equipment leasing is a subcategory of equipment financing, where you pay to use the equipment, but are not purchasing to own (sort of like leasing a car).
Invoice financing is a type of business financing available to businesses (usually B2B businesses) that frequently have a lot of cash tied up in unpaid invoices. With invoice financing, a lender will extend you a line of credit based on the value of your unpaid invoices, and you repay your LOC as you collect on your invoices. Due to the often high fees involved, you should generally only choose this option if unpaid invoices represent a heavy burden to your business, and you need immediate cash.
Invoice factoring is similar but slightly different.
With this type of financing, you actually sell your invoices to a factoring company, at a pretty steep discount. It then becomes the factor’s responsibility to collect on these invoices. Learn more about the differences between invoice financing and invoice factoring.
Every lender’s application is a little bit different, but most follow the same three stages: prequalification, verification and underwriting, and funding.
In the prequalification stage, you will need to fill out detailed information about you, your business, your business’s finances, and what you’re looking for in a loan. The information at this stage is normally unverified, though of course, you should still be as accurate as possible.
Some lenders will also allow you to complete this stage informally over the phone or online.
An underwriter, or, often, a computer, will look at your application and determine if you’re qualified to receive funding.
If so, at this point many lenders will present an estimated loan offer to you. This offer will detail information about your potential loan, including your borrowing amount, interest rate, fees, term length, and size of periodic repayments. Ideally, the quote will also include information to help you compare loan offers, including the APR and/or the cents on the dollar cost.
If you’re still deciding between a few lenders, get an estimated loan offer from each one to easily compare your options.
Contrary to what many people think, being “prequalified” for a business loan does not mean that you are necessarily approved for funding. To be officially approved, you need to complete the next step.
Before actually giving you money, the lenders will have to verify your information. This step primarily involves supplying documentation about yourself and your business, so lenders can be sure they’ve offered you a deal that will fit your business (and that you’re not lying to them).
During this stage, lenders may ask for financial documentation. Your lender might ask for documents like these:
The faster you can hand over the documents requested by your lender, the faster the application process will go, and the faster you’ll be able to access your borrowed funds.
Many lenders also require you to complete steps to verify your identity, which may include answering basic personal questions over the phone or having a code mailed to your house.
At the end of this process, you will be presented with a final offer. In some cases, this offer may be different from the quote you received during the prequalification stage, so it’s important to go over all the information to ensure the offer is something you want. As always, before signing a contract, read the fine print.
At this point, the only thing left to do is to get funded!
After you’ve accepted an offer, the lender will send the money to your bank account. Normally this happens via an ACH transfer, which means the money will take one to two business days to transfer between banks.
When evaluating a business loan application, lenders look at various pieces of information to determine whether it’s a good idea to lend to you. In addition to looking at your time in business, credit score, and revenue, lenders also consider how you stack up against the 5 C’s of credit and data points like DSCR and DTI.
Lenders consider the following traits, also known as the “5 C’s of Credit,” when considering whether to lend to a business:
While these are somewhat general traits, they paint a good overall picture of how likely your business is to repay your loan on time.
Your personal credit score is a measure of how well you’ve repaid your debts in the past. Lenders want to be sure that you, the business owner, have a history of repaying debts in a timely manner. After all, if you have a history of responsibly repaying debts, you’ll likely continue to do so in the future.
The longer your business has survived, the more likely it is to do so in the future. Before granting your business capital, lenders want to be sure that your business has withstood the test of time.
Loans with longer term lengths often require a longer time in business.
Quite simply, your business has to be making enough money to repay the debt. The amount of revenue you’re currently making determines the maximum loan size you will be eligible for—often lenders won’t let you borrow more than 10% – 15% of your annual revenue.
Your debt service coverage ratio (DSCR) basically tells your lender (and yourself) how much money you have available to repay additional debt or make periodic loan payments. Your DSCR is calculated using this equation:
Net Operating Income / Total Debt Service = DSCR
A DSCR higher than one means that you are making enough money to cover your current debts, and you could manage more debt without a problem. Usually, lenders like to see that you have a DSCR of 1.15 or above.
A similar data point lenders consider is your debt-to-income ratio (DTI), which is expressed as a percentage. This is the DTI ratio formula:
Total Monthly Debt / Gross Monthly Income = Debt-To-Income Ratio
Acceptable DTIs vary by lender, but generally, a DTI of 36% or lower is considered good. However, some lenders will be able to finance you if you have a DTI as high as 43%.
Loan repayment is usually pretty straightforward, but methods can vary somewhat from lender to lender. The length of a loan’s term will of course vary from one loan to the next—and it will obviously make a big difference whether you have to repay the loan within three months or five years. Other than that, the main differences between loans, in terms of repayment, are whether the loan repayments are fixed or variable, and how often you have to make payments (payment frequency). You may also have some flexibility in how you repay (payment method), but generally, loan repayments are automatically deducted from your bank account.
Borrowers with a fixed repayment pay the same amount every time they make a payment. For example, a borrower might have to pay $341 on a bi-weekly basis until the loan is paid off. Barring extraneous circumstances, the borrower will never pay more or less than the $341.
Variable repayment means that the amount you’re paying may change. You may have a variable repayment schedule for one of two reasons:
In the past, almost all loans were paid on a monthly basis. These days, lenders may require payments in many different intervals, including monthly, bi-monthly, weekly, or daily. Daily repayments are generally only made every weekday, excluding bank holidays.
Gone are the days when you have to remember to write and mail in a check (mostly). Now, most lenders opt for an automatic repayment system, in which your payments are deducted right out of your bank account via ACH. All you have to do is make sure the money is in the proper bank account.
Some still allow payment via checks. However, many charge a check processing fee, which can cost your business a significant cost of money over time.
Business loans are excellent tools for increasing your liquidity so that your business can thrive in good times and bad. However, it’s important to know how loans work in general, as well as the terms and conditions of any particular loan you are applying for.
The best small business lenders are as transparent as possible, both on their websites and in their communications with applicants. Predatory lenders, on the other hand, tend to hide behind too-good-to-be-true advertising, while offering few (if any) specific details about their lending products. Before signing on for a loan, make sure you understand how much your payments will be, how frequent they will be, and how much you will pay for the loan in total.
Use our small business loan calculators to help figure out these important details.
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