How Do Business Loans Work? Here’s Our Intro Guide

If your small business could use additional funds to boost growth, SmartBiz Loans is here to help. We’ve outlined the type of business financing available for small business owners and how you can take advantage of available resources.

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When should I consider getting a business loan?

There are many ways funds from a business loan can be used to shore up your business. If you need money for the following, it’s a good time to seek funding.

  • Staffing costs
  • Purchase and upkeep of essential equipment, including vehicles used for work purposes
  • Rent for mortgage payments
  • To refinance expensive debt and lower your monthly obligations
  • Marketing
  • Inventory
  • New product development

How business loans work

A business loan is somewhat similar to a personal loan. It’s debt financing from a lender that must be paid back in full on a schedule along with agreed upon interest, fees, and other costs. In general, interest is charged as a percentage of the loan’s principal.

Short-term loans

These loans work like long-term loans, except that they have to be paid back in a shorter period of time. They typically have smaller amounts, more frequent payments, and higher APRs. Although they can be quick and convenient, short-term loans can cost you a steep price. It can be easier to qualify for a short-term loan, but you might find that they’ll negatively impact on your business cash flow in the end.

A good reason to take out a short-term loan is to build your credit. Paying back on time in full will give your credit score a boost and make it easier to qualify for longer term loans in the future. Another reason is to jump on a business opportunity, like buying inventory in bulk, as these loans generally take less time to fund.

Learn more here about short-term (2 to 5 years) Bank Term loans available through the SmartBiz bank network: Bank Term Loans.

Long-term loans

Long term loans can be 10-years up to 25 years for a commercial real estate loan. Long term loan payments are much smaller, making it easier on your cash flow.

SBA Loans

If you qualify, the Small Business Administration’s low-cost loan programs can be your best option. SBA 7(a) loans have low rates, a 10-year term and very low payments to fuel stability, growth and savings.

The 7(a) Loan Program

An SBA 7(a) loan can be used for a variety of purposes.

  • Working Capital – Purchase equipment, add marketing programs, for operating expenses, or to hire additional staff. For additional information, read What is Working Capital in Small Business.
  • Debt Consolidation Loans – To get up and running, a business owner might have relied on expensive debt. An SBA 7(a) loan can be used to refinance merchant cash advances, short-term business loans, high interest business loans, daily or weekly payment loans or business credit cards. Learn more here: Refinance Your Business Debt by Learning More About Refinancing.
  • Commercial Real Estate – Refinance an existing commercial real estate mortgage or purchase a new space for your practice. Learn more here: Commercial Real Estate Loans.

For in-depth information about the popular SBA 7(a) loan program, visit the SmartBiz Small Business Blog and review our comprehensive article: What is an SBA Loan?

There are plenty of non-SBA loan options available although they may have higher rates, shorter terms and larger payments.

Business Lines of Credit

A business line of credit allows you to borrow funds up to a limit based on your credit, typically smaller than a term loan. You only pay interest on the amount you use, and you can continue borrowing as necessary until you reach the set maximum. These loans are usually unsecured, meaning that you won’t have to provide collateral to qualify. For in-depth information, read this post from the SmartBiz Blog: Small Business Lines of Credit Pros and Cons.

Business credit cards are revolving lines of credit. The main distinction is that they don’t terminate once the predetermined limit is reached. They work like personal credit cards, with varying spending rewards and offers depending on the lender. Learn more here: 5 Business Credit Card Myths.

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Merchant Cash Advances

A merchant cash advance (MCA) is most often used by businesses that accept credit and debit card sales. You receive a specific sum in advance that is repaid either by a percent deduction from daily transactions or through daily or weekly payments.

Keep in mind that MCAs often lead to extremely high annual percentage rates. Even the minimum within the range can be several times larger than term loan annual percentage rates and can reach up to well over 300%. For more info, read What You Need to Know About an MCA.

Equipment loans

An equipment loan is a form of small business financing that is used specifically for equipment purchases. If you don’t want to purchase an item upfront, you can use the funds from the loan to expense the cost and then repay the principal over a longer period of time. That way, you can divide up the cost into more manageable payments.

Invoice Factoring and Financing

Invoice factoring is not a loan in the traditional sense. Instead, you sell your customer invoices to a factoring company in exchange for a specified sum. They take care of collecting the payments, which means you can receive funds more quickly.

Invoice financing is slightly different. You maintain control of your invoices, because instead of selling them to a factoring company, you use them as collateral when applying for a short-term cash advance.

Applying for a loan – required documents

When you find a lender, several important financial documents will be required. This can vary by lender to lender. It’s a good idea to work with an accountant or bookkeeper to help you gather paperwork. Note that if you have strong credit scores, you’ll be able to get a lower cost loan faster.

Documents required

  • Business tax returns (3 years)
  • Income statements (year-to-date)
  • Balance sheets (year-to-date)
  • Schedule of liabilities (list of all business debt)
  • Personal tax returns (3 years)
  • Personal financial statement

Loan application tips

Protect your credit score

Don’t put in multiple applications as your credit could lower with each inquiry. Find a lender who does an initial “soft pull”, also called a “soft inquiry” of credit. Bad credit can sink your chances to qualify for low cost funding. For information on this, read Hard and Soft Pulls of Credit: What you Need to Know.

Work with a lender who values transparency

Unfortunately, not all small business lenders are on the up-and-up. Confusing language and calculations can result in paying much more than you think you signed up for. Make sure you work with a financial professional who is responsive and answers all questions clearly. Stellar customer service is key.

Questions to ask when comparing financing options:

How much do I want to borrow?

Take a look at your business plan to determine where you currently stand and where you want to go. Create financial goals and speak with your accountant to nail down an amount. Look at the cost of the loan and all fees to get the true cost.

When would I like to repay the loan?

Long term loans generally have the lowest rates and 10 years or more to pay off. If you’re in it for the long haul, long term is best. If you plan on early payoff, check with your lender about penalties.

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