When your business needs funding, you might be tempted to get it from the fastest possible source. That approach is understandable, but it can backfire, as fast funding routes are often more expensive. Instead, you should take some time to explore all your options and decide which loan type is best for you. This guide to how to choose a small business loan can help you do exactly that.
How to choose a small business loan in 8 easy steps
Choosing the right loan for your business can be a long process. That said, each individual step is generally pretty straightforward. Below are some tips to help you properly evaluate your options.
1. Be clear about why you need a loan
If you need more money to hire more employees, your funding options might be different than if you’re looking to upgrade your equipment. That’s why saying “I need more money” isn’t quite enough when searching for the right loan.
Instead, you need to say, “I need more money because I need to hire more people to keep up with demand.” This way, when you speak with a small business lending expert, they can point you toward loans approved for funding new hires.
2. Figure out how much money you need
Let’s say you need to buy machinery that costs hundreds of thousands of dollars. In that case, a $50,000 microloan might not get you over the line. When you determine how much money you need, you can eliminate certain loan categories right off the bat. That means no spending time applying for loans that ultimately won’t fit the bill.
3. See whether you qualify for a loan
Applying for loans if your business is brand new can be challenging. That’s because some types of loans are unavailable to small business owners with companies that haven’t existed for a certain amount of time. Your age, credit score, citizenship status, and bankruptcy history could also affect your eligibility. Find the qualification requirements for any loans you’re interested in to be sure.
4. Figure out how much you can pay per month
Taking out loans means repaying them monthly. Your monthly payments will comprise more than just the loan amount – they’ll also include interest and fees. Use the percentages or flat amounts for these additional payments to determine whether your total monthly payment will fall within your budget. Keep in mind that some loans are amortized, meaning that the interest you pay on them decreases over time.
5. Decide whether you’ll put up collateral
Some small business loans will require you to put up certain assets as collateral. These loans, known as secured loans, give the lender a backup plan if you can’t repay what you’ve borrowed. In that case, the borrower can seize and sell your collateral to recoup their costs. This arrangement merits the question: Are you willing to take out a loan that could result in you losing your assets? If so, which assets will you put up? Answer these questions before proceeding.
6. Look at your loan options
After you’ve worked through the above considerations, you should have everything you need to eliminate certain loan options from your list. For example, let’s say you decide you need $500,000 to buy commercial real estate for a second storefront. In that case, your list of possible loans will comprise only funding you can use for commercial real estate and that can fund your requirements.
7. Get all your paperwork together
Applying for loans is a notoriously paperwork-heavy process. You might need to present documents ranging from tax returns to business plans. Look up the paperwork requirements for several loan options available to you, then gather all the pertinent forms. Once you’ve gathered all this paperwork, you’ll know the loans for which you do (or don’t) have the right documents to apply. Consider consulting with a professional for assistance with paperwork if necessary.
8. Choose a loan and apply for It
Since the loan application process can be lengthy, you should consider initially applying for just one loan. If the lender doesn’t approve you, then you can apply to other loans instead. Don’t be discouraged if you’re denied the first go-round – plenty of other loans exist, and you can likely try your hand at those.
Types of business loans
There are six key types of business loans you should know about. Some of these loans are best for borrowers with bad credit, whereas others are only available to borrowers with good credit. Other loans may be available to borrowers with a decent, but not quite great, credit report. Below is everything you should know about these loans and the types of credit scores for which they’re best.
1. For good credit: SBA loans
Small Business Administration (SBA) loans are well-regarded among the many types of business funding options. In fact, SBA 7(a) loans are often seen as the best among all loans offered to small businesses. More information about 7(a) loans and the other two primary types of SBA loans is below.
- 7(a) loans. You can use SBA 7(a) loans to obtain working capital, consolidate your debts, or buy commercial real estate. Their interest rates are low and can be either variable or fixed. Their repayment terms can be as long as 25 years, and their amounts can be up to $5 million. They’re often fully amortizing.
- 504 loans. With SBA 504 loans, you’re only responsible for 10 percent of the loan total. A Certified Development Company (CDC) and an SBA-backed lender cover the rest if your business and the CDC share similar goals. Most 504 loans have a maximum amount of $5 million and require a small down payment. Your term will span 10, 20, or 25 years. You can use your loan proceedings to buy commercial real estate.
- Microloans. This SBA loan program offers very small businesses loans of at most $50,000. Their interest rates are typically fixed and fall between eight and 13 percent. Your microloan proceeds can cover working capital, inventory and supplies, equipment, and furniture. You can’t use your loan toward debt refinancing or real estate purchases.
Notably, the SBA backs all the above loans, and this government backing incentivizes approved SBA lenders to offer these loans. It also introduces a hefty amount of paperwork on your end to ensure you won’t default or need government assistance paying for your loan.
2. For good credit: bank term loans
If you don’t qualify for SBA loans, bank term loans can be a viable alternative. These loans typically have fixed interest rates of 6.99% to 26.99% and repayment terms of one to five years. Their amounts range from $30,000 to $500,000.
As the name “bank term loan” suggests, banks offer these small business loans. That said, credit unions, online lenders, and alternative lenders offer term loans too. You can use these loans to buy working capital or consolidate debt.
Since bank term loans lack SBA backing, they don’t require as much paperwork from their applicants, so funding can sometimes be faster. Their fixed interest rates lead to consistent monthly payments that can help new entrepreneurs further bolster their business credit score. That said, fixed interest rates ultimately lead to more expensive loans since variable-rate, amortized loans result in lower payments down the line.
3. For okay credit: business lines of credit
Business lines of credit are similar to credit cards, but they expire after you use their balance. You’re not required to use the full credit line, and you’ll only pay interest on the portion you do use. Small business owners often use them to fund payroll, inventory and equipment purchases, and marketing campaigns.
Business credit lines often have high interest rates, which can make them disadvantageous. Their rates typically increase as your credit score decreases. That said, they can be easier to qualify for than SBA or bank term loans.
4 For okay credit: equipment financing
Equipment financing can be a reliable loan option if your credit score is in the 600 to 675 range. You’ll use equipment loans, as their name suggests, to buy new equipment or update old machinery. Once your loan term ends – often after five years – you can buy the equipment. If you fail to repay the loan, the lender will likely seize the equipment as collateral. This arrangement can put your business back at square one, but it does protect your other assets.
5. For bad credit: merchant cash advances
If your credit score is low, merchant cash advances (MCAs) can help you maintain your cash flow. For starters, many MCA providers won’t ask for your credit score. MCAs are also convenient: You’ll receive a loan, and then every day, you’ll funnel a portion of your credit card revenue to the lender. This arrangement is an especially passive form of loan repayment.
MCA providers check your credit card processing statements to determine your eligibility. If your transaction volume is high enough, you’ll likely qualify. However, your loan will probably come with extremely high interest rates and fees. You also can’t take out a merchant cash advance if your business doesn’t accept credit card payments.
6. For bad credit: invoice factoring and financing
Like merchant cash advances, your access to invoice factoring services is mostly independent of your credit score. Notice the word “services” there: Invoice factoring isn’t a loan in the traditional sense. Instead, an invoice factoring service buys any invoices that your clients or customers haven’t paid. The company will lend you the total invoice amount, charge you a fee, and interact directly with the client or customer for payment.
If clients sitting on unpaid invoices is your main obstacle to cash flow, invoice factoring can be a reliable funding option. That said, you’ll pay a weekly fee until your client repays, though the invoice factoring service often refunds some of this fee.
Why is a business loan the best funding option?
A business loan is important because it helps your company get funding, but there’s more value to it than that. Namely, a business loan is often a better option than other funding routes. Below are three reasons why business loans often prove superior.
- Fast funding. Some lenders can make funding available to you in just a matter of days. With others, you’ll wait at most a few months for funding. By comparison, if you seek funding from angel investors or venture capitalists, you could wait up to a year to receive the money you need.
- Business control. Angel investors and venture capitalists typically obtain ownership equity in your company for the money they give you. If you give them enough ownership equity, you could lose some control over your operations. Business loans present no such issue. Lenders don’t get a seat at your table.
- Low interest rates. Many entrepreneurs have business credit cards, which are great for small purchases you know you can pay off soon. However, let’s say you use your credit card for a purchase you wind up unable to pay. In that case, the card’s high interest rates can quickly make your purchase much more expensive. Business loan interest rates are much lower and add relatively little to your business expenses for big purchases.
The right loan for your business
Any loan you choose should be eligible for use in ways that suit your needs. It should also come with eligibility requirements that you can easily fit. You should also seek low interest rates and long repayment terms to make your payment installments smaller. Just as importantly, you should borrow from a lender that makes its team readily available to you whenever you need help.
On that front, SmartBiz® is a great option. You can apply for SBA 7(a) loans, bank term loans, and custom financing with easy access to a dedicated support team. We’ll match you with the bank whose loans check all your boxes, and you’ll get the capital your business needs. Just create a SmartBiz account to get started.
WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.