Lenders of small business loans let you borrow money for your business and pay it back over time. Read on to learn how five popular types of small business loans work.
Small business loans can help you get the capital you need to start or grow a business. You then pay back the amount, plus borrowing fees, over time in a way that fits into your budget. But, how exactly do they work? It depends on the type you choose. Read on to learn the ins and outs of five popular types of small business loans so you can find the best fit for your situation
What is a small business loan?
A small business loan is a financial product designed to help small business owners finance the cost of starting, growing, and/or operating their businesses. For example, the loan funds are often used for purposes such as stocking up on inventory, purchasing new equipment, buying real estate or commercial vehicles, implementing marketing strategies, or hiring new employees. On the flip side, small business loan lenders charge interest and fees to earn a profit from the money they lend out. The specific way a loan works, however, varies depending on the type you get.
5 common types of small business loans
Small business loans come in many forms and each works a bit differently. Here’s an overview of five of the common types.
1. Term loans
Term loans provide businesses with a lump sum upfront that gets repaid, plus interest, through fixed payments over a set term. Lenders charge interest based on an annual interest rate, and may also charge an upfront origination fee that gets deducted from the loan amount. You can find business term loans from a variety of lenders including banks, credit unions, and online lenders. You can also find them in unsecured and secured forms. When secured, they may be referred to by the form of collateral that secures them, such as equipment loans, commercial real estate loans, and auto loans, and may require a down payment.
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Example:
Your business accepts a $50,000 unsecured term loan with a 60-month term, a $150 upfront origination fee, and a 15% fixed interest rate. You would receive $49,850 and would be required to repay the full $50,000 plus interest through 60 monthly payments of approximately $1,189. In total, the interest would cost you $21,340.
2. SBA loans
The U.S. Small Business Administration (SBA) offers a lineup of business loan programs, including:
- 7(a) loans: Term loans up to $5 million to help small businesses finance a variety of expenses from real estate and equipment to supplies and furniture
- 504 loans: Term loans up to $5 million for major fixed assets such as land, buildings, and long-term machinery and equipment
- Microloans: Term loans up to $50,000 to help small businesses and certain non-profits start up and expand
SBA loans are made available through approved intermediary lenders and are backed by the SBA. They can be advantageous because they come with competitive rates, counseling and education, and other benefits like low fees. However, the application and approval process can be tedious and time-consuming. The SBA program also may not be available to all borrowers as it’s intended for people who can’t access financing on reasonable terms from non-government resources.
Example:
Your business gets approved for a $500,000 7(a) SBA loan with a 60-month term and an interest rate of 11.5%. You would owe monthly repayments of approximately $10,996 for 60 months. The total cost would be $159,760.
3. Lines of credit
Lines of credit provide your business with access to a revolving credit line you can use, repay, and use again. Once you withdraw from the credit line, interest often begins to accrue on the outstanding amount. Similar to credit cards, lenders often require you to make minimum payments to cover the interest. You then repay the principal amount as you can or may be required to pay it down within a certain timeframe. Lenders may also charge fees for origination, maintenance (annual or monthly), withdrawals, or inactivity.
Example:
Your business takes out a $50,000 revolving credit line with a $175 annual fee and a 15% interest rate. You’re required to pay $175 each year the credit line remains open. Additionally, interest will accrue on your outstanding balance according to the 15% interest rate which you’d be required to pay off each month. The total cost of the credit line will depend on the balances you carry while you have it.
4. Credit cards
Business credit cards also provide a revolving credit line you can use, repay, and use again. When you make purchases, card providers often wait until the end of the billing cycle to begin charging you interest. However, cash advances and balance transfers often begin accruing interest right away. If you carry a balance beyond a billing cycle, you’ll only be required to make a minimum monthly payment. However, it’s beneficial to pay off the total balance as soon as possible to limit interest charges.
Example:
Your business gets approved for a $5,000 business credit card with a $99 annual fee and a 20% APR. You’ll be able to charge up to $5,000 to the card but will be charged interest on any outstanding balance you carry beyond a billing cycle. If you carry a balance over, you’ll have a minimum required monthly payment that’s based on the amount you owe. They often range from 2% to 4% of the balance. Additionally, you’ll owe $99 each year on the anniversary of opening your card. The total cost will depend on the balances you carry while the card is open.
5. Invoice financing
Invoice financing allows businesses to borrow against their outstanding invoices and get paid earlier. Upon approval, lenders let you borrow some or all of the amount owed to your business and use your invoice as collateral. Then, when your client pays, the lender is repaid the loan amount plus the applicable borrowing fees.
Example:
Your business gets approved to borrow 85% of a $10,000 invoice due in 60 days. The lender charges a 3% processing fee and 1% per month until the loan is repaid. You receive the $8,500 loan and your client pays on the 60th day. You then owe the lender 5% ($500) and would receive the remaining 10% ($1,000). The total cost for a 60-day loan would be $500.
What are the eligibility requirements for small business loans?
The eligibility requirements for small business loans vary by the type of loan you’re seeking and the lender you choose. However, here are some of the common requirements:
- Time in business: A minimum amount of time in business under the same ownership, such as six months to two years
- Location: Physically located and operated from the U.S. or its territories
- Credit scores: Business and personal credit scores that are above a certain minimum threshold
- Annual revenue: Annual business revenue at or above a certain minimum
- Tax ID: An active Employer Identification Number (EIN) registered with the IRS
- Collateral: When a loan is secured, assets such as invoices, equipment, land, machinery, or real estate that are approved
- Business checking account: An open and active business checking account
- Personal guarantee: A personal guarantee from owners with a minimum percentage of ownership (in some cases)
- Restricted industries: A business type that is not restricted by the lender (e.g. gambling, adult entertainment, drug dispensaries)
As you research small business loan options, you’ll want to review each lender’s requirements to see if it’s a good fit as they can vary greatly. For example, OnDeck requires one year in business, a 625 personal FICO score, $100,000 in annual business revenue, and a business checking account. On the other hand, Bank of America requires a personal credit score above 700 and two years in business, in addition to $100,000 in annual revenue.
Frequently asked questions about how small business loans work
Is it hard to get a loan for a small business?
The newer your business, the lower your annual revenue, and the lower your personal credit scores, the more difficult it will be to get a small business loan. The good news is that there is no shortage of loan options. Online lenders tend to be the most lenient, while banks are more strict. The SBA also has lenient eligibility requirements but has a lengthy and involved application process. If you’re having trouble getting approved, a secured credit card can be a good way to get in the door and start building positive business credit.
How much can I realistically get for a small business loan?
Small business loans range from hundreds of dollars up to $5+ million. The amount you can borrow will depend on the loan type you choose, the loan range of the lender you choose, and the amount you qualify for based on the revenue and creditworthiness of your business. The best way to find out is to request quotes from business loan lenders.
How much of a down payment is needed for a business loan?
Down payments aren’t required on many types of business loans. For example, while you may have relatively small upfront fees on credit lines, term loans, and credit cards, you often won’t have to make a down payment. However, they are more common with certain SBA loans, commercial real estate loans, and auto loans.
What credit score is needed for a small business loan?
The credit score needed for a small business loan varies by lender. For example, Bank of America requires business owners to have personal FICO scores of at least 700, while Ondeck accepts personal FICO scores as low as 625. You’ll need to shop around and check the requirements of the lenders you’re considering.
