How Does a Business Loan Work?

how business loans work

When you’re starting or expanding your own business, one of the most important things for success is having access to capital.

Finding the right loan for you and your business is important, and this guide will walk you through the different types, the qualifications you will need to meet, and the terms of repayment for each. 

What Are the Types of Business Loans?

There are several different types of business loans on the market. The type that you need will mostly depend on why you need it. Here is a quick overview of the different types and how they work.

Business Lines of Credit and Credit Cards

Business lines of credit and revolving lines of credit are used interchangeably. The concept is very similar to that of a credit card. If you qualify, you are given a line of credit to be dispersed and used at your discretion. Interest rates could be variable, meaning they are subject to change with fluctuations in the economy or fixed. Interest is typically only charged on the amount that is accessed, and it is common for lenders to charge a fee each time you access the credit line

This type of loan is beneficial for businesses that need to purchase new equipment at a reduced cost and therefore, need capital on hand. If your business fluctuates seasonally, a line of credit would be beneficial during the slow seasons. New businesses often use credit cards or a line of credit to cover costs of labor and supplies until payments from clients start to roll in. 

Term Loans

Term loans come in three types: long-term, intermediate-term, and short-term. Short-term loans are common among small business loans. Lenders are also more likely to offer short-term loans to new businesses. Since they require relatively less time in business and lower revenue, they are usually due in full within a year and have high-interest rates. If you need quick capital in a smaller amount to get your first business started, a short-term loan is likely your best option.

Long-term and intermediate-term loans are reserved for companies that have been in business for a few years and can prove strong revenue and cash flow. These are basically standard business loans. Borrowers have anywhere from 2 to 10 years to repay using monthly installments, and interest rates are lower than short-term loans. 

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Merchant Cash Advances

Merchant cash advances work if you need cash in hand and have a steady history of somewhat consistent revenue. They are relatively easy to get but can be more costly than term loans. Put simply, a merchant provides you a cash advance with the understanding that you will repay it with a percentage of your future sales. Therefore, payments may fluctuate depending on your revenue.

Invoice Financing and Factoring

Invoice financing entails receiving a loan based on an invoice from accounts receivable. You provide an outstanding invoice as collateral, and the lender will allow you to borrow anywhere from 80 to 100 percent. Repayment comes from the invoice when it is paid. This option is most beneficial for companies with a net of 30+ invoices and less time in business. 

Invoice factoring is most beneficial for larger businesses. If you have a stack of invoices in accounts receivable, you can sell them to a vendor for a portion of the total amount upfront. Once the invoices belong to the vendor, they will collect payment and give you part of the remaining amount after deducting factoring fees. 

Commercial Real Estate Loans

Commercial loans, such as small business loans, are designed to provide working capital to cover existing costs or help expansion. Commercial Real Estate loans are a specialized version. They are typically long-term and used for transactions involving real estate purchases. You might use this loan to purchase a property to flip or to start construction on land that you already own. Interest rates are usually fairly low because the property you purchase is used as collateral. Repayment can extend to up to 30 years. 

SBA Loans

SBA loans are provided by lenders who have been approved by the Small Business Administration (SBA). They are typically long-term and have low-interest rates. The six types of SBA loans are:

  1. Microloans include up to $50,000 in working capital.
  2. 7(a) loans include up to $5 million in working capital.
  3. Disaster loans aid businesses that have been affected by natural disasters.
  4. Export loans are used by businesses that deal in exports.
  5. CDC/504 loans are for commercial real estate purchases.
  6. CAPLines are a general line of credit.

Only disaster loans are issued by the SBA; all others are provided by various lenders, including but not limited to banks and credit unions. 

small business loan

Equipment Financing

Equipment financing involves specialty loans used to purchase equipment for your business. You can use them for any type of equipment, including vehicles. Interest rates are typically low because the loan is secured using the equipment you purchase as collateral. These are often considered a bit risky because they are usually long-term loans. You’ll want to ensure that the equipment you plan to buy is worth the investment and will outlast the term. 

What Are the Requirements for a Business Loan?

Business loan requirements vary based on the type of loan. However, there are some general requirements for most to varying degrees of importance and value. Your level of qualification will directly affect which loans you can get and how expensive they will be for you.

Credit Scores and Reports

Venders often check your personal and business credit scores. A poor credit score does not necessarily mean that you will be denied; it can mean that you will receive a loan with a much higher interest rate or a shorter term for repayment. New business owners can expect vendors to base their loans on personal credit history. This is partly because lenders will sometimes require personal assets to secure the loan. 

Generally, lenders will require a full credit report as well. While a good or excellent credit score is an indicator of reliability, a full report will give the lender a better idea of your history. They search for any record of accounts in collections, the number of missed payments, and bankruptcy, both personal and business. Credit reports can also help if your credit score has you leaning toward risk.

Business Financials

If you are applying for a business loan, any lender will want a record of your business financials. It varies by lender but you can expect to provide financial documents, such as:

  • Statements showing profits and losses,
  • Bank statements
  • Tax returns
  • Proof of steady cash flow
  • Business balance sheets
  • Your projections for the future

A strong financial standing will likely lead to a better loan with lower interest rates and a longer repayment schedule.

Amount of Time in Operation

Your time in business is another indicator of reliability. Lenders prefer businesses that have been in operation for several years and have financial statements to prove stability. Certain loans, such as SBA loans and business lines of credit, are conventionally given to businesses that have been in operation for several years. Startups and first-time business owners have fewer options, as discussed in the types of loans above. 

What Are the Terms of Repayment?

The terms of repayment also depend upon the type of loan you receive. In general, there are two types of loan repayment options: installment and revolving. Installment loans are most common, and the full amount of the loan is provided upfront. Repayment is routinely in fixed monthly amounts.

Payments for business lines of credit and credit cards are characterized as revolving. Your monthly payments are based on the amount of the loan you have accessed.  

As you prepare for your business loan, take the time to consider all potential lenders. They often vary in requirements like credit score and collateral needs but your time is valuable and finding a lender that moves at your pace is important. For more information on business loans, visit the Platform Funding website. 

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