How To Get A Small Business Loan: The Step-By-Step Guide
It doesn’t matter what type of small business you own. You automatically have something in common with every other small business owner: you need money to function. Without money, your business isn’t going to be successful. Without money, you can’t pay your employees or even yourself. Without money, you’ll never be able to grow and scale your business.
Most small business owners know the importance of capital, which is probably why you’re here. You need money, and you’re considering a small business loan. However, like any smart business owner knows, taking on debt without knowing the facts can be dangerous. Accepting a high-interest loan, taking money without having a clear plan for how to use it, or otherwise being irresponsible with borrowing can lead to unpaid debt, collections, or worse, the bankruptcy and closure of your business.
While this isn’t meant to scare you, it is intended to show you the importance of borrowing with prudence and foresight. In order to borrow responsibly, it’s important to understand the small business loan process. Many owners don’t know where to begin.
- How hard is it to get a small business loan?
- How big of a loan can I get for my business?
- What do I need for a small business loan?
If you’ve asked yourself any of the above questions, this guide is for you.
You are taking the critical first step to making the smart, responsible choice when it comes to small business loans. This guide will walk you step-by-step through the small business lending process to help you determine whether taking out a loan is truly best for your business. Whether you’re wondering how to take out a small business loan to start a business or how to get a business loan without collateral, this guide will help you every step of the way. Read on to find out more.
Table of Contents
- 1) Determine How You Will Use The Money
- 2) Decide How Much Money You Need…
- 3) …And How Much You Can Afford To Borrow
- 4) Check Your Credit Score
- 5) Decide What Type Of Loan You Need (& Will Qualify For)
- 6) Research Possible Business Lenders
- 7) Prepare Loan Application Documents
- 8) Apply For Business Loans & Compare Offers
1) Determine How You Will Use The Money
How do you get a small business loan? The primary action you should take before even thinking about filling out a loan application should be to determine how the business loan proceeds will be used. In other words, why do you need a loan?
There are a variety of legitimate reasons for business owners to take out a small business loan:
- To upgrade facilities with the purchase of new equipment.
- To buy land.
- To purchase office space or buildings.
- To refinance high-interest debt.
- To hire new employees.
- To cover payroll.
- To purchase inventory or supplies that may be needed due to seasonal increases.
- For working capital.
- To start a new business.
- To fund a start-up project.
- To acquire another business.
- To buy a franchise.
A small business loan can provide capital for just about any business expense. It is up to you to determine what expenses you have, how the funding will be used, and whether or not this will contribute to the growth of your business. A small business loan should only be used to benefit the business over the long term.
2) Decide How Much Money You Need…
Once you’ve determined why you need a small business loan, the next step is to figure out exactly how much you need. Taking out a loan for an excessive amount of money that’s not needed could result in unnecessary extra fees and interest payments.
Figuring out how you will use the money will help you determine how much you need. Run through calculations of your potential expenditures. Consider all scenarios when making these calculations. Do your research. For example, if you’re looking to expand your facilities with the purchase of commercial real estate, look at comparable properties online to get an idea of how much you will need to borrow. If you plan to purchase new equipment, compile a list or spreadsheet of related costs to give you an overview of how much money you need.
Not only will this help you save on interest by not over-borrowing, but it is also necessary for the application process. Lenders will want to know why you want to borrow the money. Doing your research ahead of time and having a logical response for how much you need and why you need it is a critical step in applying for a business loan.
3) …And How Much You Can Afford To Borrow
While calculating the amount of your loan is important, also remember that there are limitations on how much you can borrow. To understand how to get a small business loan from a bank or other lender, you need to know the various calculations used throughout the loan process to determine how much you can afford to borrow.
One of the first things that will be considered is the Debt Service Coverage Ratio, or DSCR. This number is determined by dividing your annual net operating income by the annual debt payments of your business. The resulting score is used as a metric for determining loan amounts and terms.
Debt Service Coverage Ratio = Annual Net Operating Income / Annual Debt Payments
The DSCR of your business should be higher than 1. This shows lenders that you will be able to make your loan payment even with other debts.
For example, if the annual net income of a business is $150,000 and annual debt payments are $100,000, the DSCR would be 1.5, showing the lender that the business can afford to pay the principal and interest on a loan because income exceeds debt payments.
Another calculation used by traditional lenders is the Debt-To-Income Ratio, or DTI. This formula is used to show the relationship between the debt of the business owner and the owner’s monthly income. To calculate DTI, total monthly debt is divided by gross monthly income.
Debt-To-Income Ratio = Total Monthly Debt / Gross Monthly Income
Let’s say the business owner brings in $5,000 per month in income. The business owner’s monthly debt payments total $2,000. Plugging this into the formula shows that the DTI is 0.4 (or 40%).
In this example, the DTI is a bit high. Ideally, DTI should be around 36% or lower. While some lenders will still finance business owners with higher DTIs, approval may be more difficult and terms may not be as favorable.
Finally, it is important to understand your return on investment, or ROI. This simply means that the total cost of the loan, including interest and fees, is less than the profits that will come in as a result of getting the loan. For example, let’s say you need a loan to hire more employees. With more employees, you will be able to complete more work for your customers and make more money. Over time, this increased productivity will more than pay for the loan.
Understanding the lending process and whether you can afford to take on a business loan is a critical step to take before accepting a loan offer. Read on to learn more about how you can determine if your business can afford to take on a small business loan.
4) Check Your Credit Score
As with any other loan, a small business loan requires you to have a strong credit score in order to receive the best rates and terms. Before applying for a loan, you need to have an understanding of your credit score and know what’s on your report.
You can get started by obtaining your free credit report online. Read through your report thoroughly to check for any errors that may need to be disputed through the credit bureaus. Take note of any negative items, including but not limited to collections, charge-offs, missed or late payments, or a high number of inquiries. Negative marks will need to be explained to your lender.
How Do I Improve My Credit Score?
Uh-oh. You’ve pulled your credit report and score, and it’s not where it needs to be to get an affordable small business loan. Don’t worry; this shouldn’t be seen as a roadblock, but instead, as an opportunity to boost your credit and understand your finances while putting you on the path to responsible borrowing.
There are several easy ways to boost your business credit score. If you haven’t already, run through your credit report and find any errors. Any erroneous information will need to be disputed with the credit bureaus. This information will be corrected or in some cases deleted, which can instantly boost your score.
Make sure to continue to pay your bills on time every month. Not paying your bills at all or even paying them late will make your credit score take a hit. If something has occurred that prevents you from paying, contact your creditors immediately. In many cases, a grace period is extended. Face your debts head on and never ignore your obligations – or calls from creditors.
To improve your score, you also want to make sure that you keep your credit utilization low. Your credit utilization should be 30% or lower. This means that of your available credit, only 30% or less has been used. If you have high credit utilization, work to pay off as much debt as possible in the shortest amount of time in order to bring your ratio down.
Finally, don’t fall victim to companies that offer to boost your credit score. These services often come at a high price and don’t do anything to your credit report that you can’t do yourself. Read on to learn more about raising your credit score.
Can I Get A Small Business Loan With Bad Credit?
How easy is it to get a small business loan with a bad credit score? While it is possible to get a small business loan with bad credit, the best rates and terms are available to business owners with the highest credit scores. Instead of wondering how to get a small business loan with bad credit (which often involves very high interest rates and fees), shift your focus to increasing your credit score.
While credit score requirements vary across lenders, it’s generally recommended to have a score at least in the high 600s in order to qualify for a business loan. Other options may be available for anyone with scores in the lower 600s or even the 500s, but these are often short-term loans with higher interest rates and lower maximum amounts.
5) Decide What Type Of Loan You Need (& Will Qualify For)
You’ve determined what loan amount you need and how you will use these funds. You’ve reviewed your credit report and score. Now, it’s time to determine the type of loan that will fit your needs, as well as the loans that you will be qualified to receive.
A term loan (or installment loan) is one of the most common types of small business loans. These traditionally-structured loans provide a specific amount of money at a specific interest rate for a set period of time. Interest rates for term loans can be fixed or variable and typically have a monthly repayment schedule. These loans are best for funding large investments, from hiring a team of employees to purchasing commercial real estate.
Term loans are typically the most difficult to qualify for and usually require collateral. Applicants should have a strong credit history, and most businesses that qualify will already be well-established, although loans for startup businesses are available as well.
Short-term loans are loans that are meant to be repaid in one year or less. Sometimes, terms may be much shorter depending on the lender selected.
There are a few different situations where short-term loans may be the best choice. If there are cash flow issues, seasonal upticks that result in rising operational costs, or an unexpected business emergency, a short-term loan may be an option to consider.
These loans are often funded very quickly but are available in smaller amounts than term loans. The short-term loan process is often much easier than the process of applying for term loans, and the requirements (including credit score) are less stringent. However, these loans can come with much higher interest rates than their long-term counterparts, so this type of financing may be very expensive for a small business.
Business Line Of Credit
A business line of credit is similar to a credit card. A small business is provided with a credit limit. The business can spend up to the amount of the credit limit and can make multiple draws if needed. Interest is paid on the funds that have been spent. Payments are made on a scheduled basis.
A business line of credit can be used in many situations. Emergency expenses, purchasing inventory during a busy season, or cyclical cash flow shortages can be funded using a business line of credit. Getting approved is quicker and easier than applying for a term loan, and requirements, including credit score and time in business, are less strict. However, interest rates are typically higher. Because it’s easy to use lines of credit, it’s important to be responsible and only draw on the line of credit when necessary.
A startup – or a business that has been in operation for less than 2 years – may find that obtaining credit is difficult. This is because the business doesn’t have the documentation to prove that it’s a successful, established business. Other entrepreneurs have big ideas but aren’t sure how to get a loan to start a small business.
In these cases, there are loans available for startup businesses. Startup loans can be used to fund new projects, for research and development, to purchase new facilities, and other expenses. Business owners that apply for startup loans won’t be required to show traditional documentation such as three years of business tax returns. However, a solid, detailed business plan and future financial projections will be required to prove that the business has the potential to be successful.
Businesses that need new equipment can take advantage of equipment financing. These loans are used exclusively for the purpose of purchasing equipment.
Equipment loans are similar to term loans in that the total cost of new equipment, plus interest, is broken down into affordable payments. Often, these loans are easier to obtain than traditional loans, especially for borrowers with lower credit scores.
Invoice financing is a form of lending that allows business owners to borrow against money that is owed to them by their customers. With invoice factoring, the lender purchases the invoice, paying the small business a percentage of the total invoice amount. When the lender collects payment from the invoiced customer, the remaining percentage is paid to the small business, less interest and fees.
Invoice discounting is also an option. Through this type of loan, a lender will advance a percentage of the invoice total to the small business. Once the invoice is paid, the small business will repay the loan, along with fees and interest.
This is a lending option that works well for businesses that have many outstanding invoices and need money immediately. The accounts receivables serve as the collateral for this type of loan, and borrowers with lower credit scores can be approved.
6) Research Possible Business Lenders
Now that you know the best type of loan to fit your needs and (and which you’re most qualified to receive), the next step is to find a lender. Since interest rates, repayment terms, and requirements vary by lender, it’s important to take the time to research your options in order to find the most affordable loan for your business. Read on to find out where to get a small business loan.
Banks & Credit Unions
Banks and credit unions are where most people immediately turn when they need financing. For most business purposes, these financial institutions offer great options with low interest rates and long-term repayment options.
Through banks and credit unions, small business owners can take advantage of loan options including:
- Secured and unsecured lines of credit
- Business credit cards
- Term loans
- Vehicle financing
- Equipment financing
- Commercial real estate mortgages
- Small Business Administration loans (through SBA-approved lenders)
As you can see, banks and credit unions offer a broad spectrum of loan options. While these loans come with extremely favorable terms, certain loans from banks and credit unions can be difficult to obtain. Obtaining a commercial mortgage or term loan can take weeks or even months to complete. For most lending options, banks and credit unions also require borrowers to have a very strong credit score.
Read The Best Banks For Small Business Loans for more information on specific lenders.
The Small Business Administration (SBA)
If you’re wondering how to get a small business loan from the government, look no further than the Small Business Administration. SBA loans are one of the most popular options for small business owners. The SBA, through intermediary lenders, provides funding opportunities for small business owners when traditional loan options aren’t available.
These loans are backed by the government, so intermediary lenders have more incentive to loan to small businesses. All loans are regulated by SBA standards, keeping interest rates low and repayment terms flexible.
There are some drawbacks to SBA loans, however. For most programs, a strong credit score is required. SBA loans also have a lengthy application process, and funding can take several months.
One of the benefits of the internet is that it has opened up many lending opportunities for small businesses. These loans often require less paperwork than loans obtained from banks or the SBA, and everything can be done online, from the application process to signing the final loan documents.
- Long-term loans
- Short-term loans
- Equipment financing
- Vehicle financing
- Lines of credit
- Business credit cards
- Invoice financing
Requirements for online loans may be more flexible in terms of credit scores and time in business. However, depending on the loan selected, fees and interest rates may be much higher than other types of funding.
Some nonprofit organizations provide financing options for small businesses to fund almost any type of business expense. For qualified borrowers, low interest rates are available.
Low borrowing limits imposed by many nonprofit lenders are a potential drawback for small business owners. In most cases, these loans require a strong credit score and the application process can be lengthy, similar to applying for SBA and bank loans.
Microlenders offer small loans of less than $50,000 to small business owners. These loans can be used for just about business expense.
Microloans are a great choice for startups with limited credit history or small businesses that can’t obtain funding through other lenders. Getting a microloan is one way that business owners can get a boost to their credit score to qualify for larger loans from traditional lenders in the future. For businesses that need more than $50,000, microloans will not be the best option.
7) Prepare Loan Application Documents
You’re getting closer to applying for a loan from your chosen lender. Before signing on the dotted line, though, it’s important to be prepared for the application process and know what you need to get a business loan.
Depending on the type of loan you’re applying for, paperwork requirements vary. At the bare minimum, you will be required to show the lender that you have the means to pay back the loan. Some loans, such as term loans from the bank or loans through the SBA, require much more paperwork.
Documentation requirements vary, but in general, you should expect to provide the following documents:
- Balance sheets
- Profit and loss statements
- Personal and business credit reports
- Personal and business income tax returns
- Bank statements
- Business licenses
- Franchise agreements
- Quotes from contractors and vendors
For many loans, personal guarantees from all owners may be required. This means that if the loan goes into default, the business owners can be held personally liable for the debt.
Startup businesses without proper documentation may be required to submit other paperwork, including a business plan, resumes for all owners to prove industry experience, and financial projections.
Can I Get A Business Loan Without Collateral?
For certain types of business loans, collateral is not required. For example, with equipment financing, the equipment being purchased is the collateral. For invoice factoring, the unpaid invoices serve as collateral. Smaller loans like microloans also may not require collateral, depending on the policies of the lender.
However, for larger loans, collateral is typically required. The SBA, for instance, requires all SBA 7(a) loans of over $350,000 to be collateralized. Collateral is typically in the form of business assets. However, some lenders will also use personal real estate or assets as collateral for a loan.
8) Apply For Business Loans & Compare Offers
After following the last six steps, you’re finally ready to begin the application process. Depending on the lender and the type of loan you’ve selected, you may have to visit a financial institution, call the lender, or apply online.
Before applying, it’s necessary to have a general understanding of the requirements of the lender. For example, if their small business loan credit score requirements are over 700 and your credit is 680, applying for the loan will not only be a waste of time but will also create an unnecessary inquiry on your credit report. You also want to do your research to find what lenders offer the lowest rates and best repayment terms.
When applying for a small business loan, you will have to give the lender the reason you’re applying for the loan, as well as the amount you wish to borrow. You should have all of your documentation together to include with your application. Please note, however, that lenders have different requirements and more documentation may be required depending on your chosen loan.
Personal and business credit reports will be evaluated by the lender. If there are any negative items on your credit report, you will need to explain these items to the lender. All documentation will be evaluated to determine whether you qualify for the loan, including creditworthiness and ability to pay back the borrowed amount.
After documentation has been submitted and the application completed, the approval process begins. For business credit cards or lines of credit, this could be almost immediate. For long-term loans, this process could take several weeks.
Once approved, the loan will need to go through underwriting, closing, and funding. Depending on the loan selected, the entire process could potentially take several months. This is especially true for SBA and long-term business loans from banks and credit unions.
If you’ve applied for multiple loans, such as through an online loan marketplace, compare the offers you’ve received to determine which has the most favorable rates and terms.
Once your loan has been funded, it’s time to use the money for your intended business purpose. With careful planning, these funds have the potential to take your business to the next level. The final step is to remember to always pay your loan as agreed like any responsible borrower. This proves that you are a trustworthy business and opens up more lending opportunities for the future.