How Do Small Business Loans Work & What Is The Business Loan Process Like?
If you’re wondering how business loans work, you are probably in the early stages of research for getting business financing. You have taken an important first step: gathering information about what the process is like and learning what to expect if you continue your search for a loan.
However, you might be a little nervous or unsure about the prospect of getting a business loan because you’re afraid of rejection, of predatory lenders, or of being able to make the payments. You might also be overwhelmed with all the information and not know where to begin. With this article, I hope to give you a little more confidence and a starting point for your search going forward.
Table of Contents
How Small Business Loans Work (The Short Version)
Simply put, a business loan is money you borrow to fund your business. You might obtain your loan from a bank, credit union, or alternative lender online. What sorts of reasons do businesses take out loans? Startup capital, working capital for everyday expenses, debt refinancing, expansion, construction, inventory, payroll, you name it—there are loans for every business need. Once you receive the money, typically as a lump sum, you will then start repaying on the principal, plus interest, usually in a series of installments.
So why borrow money when you’ll just have to pay it back, with interest?
Because having access to business capital opens up doors. It will allow you to keep your business going during tough times, or invest in expansion to grow your business when you’re ready. With the proceeds of a business loan, you can fund your payroll expenses during a slow season, take advantage of a good deal on bulk inventory, or open a new location for your growing business. And as long as you make all your payments on time, you’ll also build up your business’s credit profile, which will help open up access to more capital in the future.
Types Of Small Business Loans & How They Work
There are many various types of 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.
Bank, Credit Union, & SBA Loans
- Best for: Long-term investments (expansion, refinancing, construction)
- Not for: Startup capital
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.
- Best for: Medium- or long-term investments
- Not for: Short-term working capital needs
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.
- Best for: Short-term working capital
- Not for: Long-term investments
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.
Merchant Cash Advance
- Best for: Emergency cash infusion
- Not for: Long-term investments
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
- Best for: Small, frequent cash infusions
- Not for: Large, one-time investments
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 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.
Personal Loan For Business
- Best for: Startup capital
- Not for: Large investments
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.
- Best for: Purchasing or leasing business equipment
- Not for: Anything else
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).
- Best for: Turning unpaid invoices into immediate cash
- Not for: Businesses that can afford to wait for customers to pay their invoices in full
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.
What To Expect From The Application Process
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.
Verification & Underwriting
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:
- Proof of identity
- Recent business bank statements
- Recent business credit card statements
- Business tax return
- Personal tax return
- Profit and loss statement
- Balance sheet
- Debt schedule
- A/R aging
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.
How Lenders Assess Your Eligibility For A Small Business Loan
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.
5 C’s Of Credit
Lenders consider the following traits, also known as the “5 C’s of Credit,” when considering whether to lend to a business:
- Character – The borrower’s reputation and perceived trustworthiness.
- Capacity – The borrower’s ability to repay the loan.
- Capital – How much money the borrower has put toward the investment.
- Collateral – What assets the borrower has to offer as insurance in the event of a default.
- Conditions – The conditions of the loan the borrower is seeking, as well as the current state of the economy in general.
While these are somewhat general traits, they paint a good overall picture of how likely your business is to repay your loan on time.
Personal Credit Score
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.
Time In Business
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 length 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.
Debt Service Coverage Ratio & Debt-To-Income Ratio
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:
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:
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%.
How Small Business Loan Repayment Works
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.
Fixed vs. Variable Repayments
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:
You have a loan (or advance) that is repaid by deducting a percentage of your cash flow. For example, your lender might deduct 15% of each sale until the debt is repaid. These loans do not have a maturity date, because repayment is dependent upon your cash flow.
- Your interest rate is dependent upon the prime rate. If the prime rate goes up, so will your interest rate and consequently your payments. Naturally, if the interest rate drops, your interest rate and payments will as well. The prime rate is generally utilized by lenders who offer loans with long term lengths, or those that offer lines of credit.
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.
Final Thoughts On How Business Loans Work
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.
Reputable online 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.
And finally, here are a few more educational resources we think you might find helpful in your research about small business loans:
- First Time Business Loans: Learn Where & How To Apply
- Types Of Small Business Loans: 12 Types You Should Know
- Online Business Loans: What They Are & When To Get One
- Short-Term Small Business Loans: The Complete Guide
- What Business Installment Loans Are & How They Work
- Guide To Getting A Business Line Of Credit For Small Businesses
- Invoice Financing: The Complete Guide For Businesses
- What Is Equipment Financing?
Still have questions? Leave them in the comments and I’ll answer them for you.