Small Business Loan Basics: What You Need to Know Before You Apply
April 6, 2023
8 min read
The economy heavily relies on small businesses as they generate employment opportunities and fuel progress through innovation. Nonetheless, launching and operating a small business necessitates substantial funding, which can be challenging to obtain.
Small business loans play a crucial role in this scenario. Whether you aim to initiate a new business venture or grow an established one, obtaining a small business loan can offer the required financial resources to accomplish your objectives.
But with so many different types of loans and lenders available, it can be overwhelming to navigate the world of small business financing. This article will give you an introduction to small business loans, including the available choices, associated expenses, and eligibility criteria for application.
Understanding Small Business Loans
Small business loans are loans specifically designed to provide financing for small businesses. These loans are essential for entrepreneurs who need to start or grow their businesses but need more capital to do so. Understanding small business loans is crucial for any entrepreneur looking to secure funding for their business.
A small business loan is a financial product that provides a lump sum of money to a small business. This loan is then repaid over a specified period, typically with interest. Usually, small business loans are unsecured, implying that they don't mandate collateral for loan approval. Nevertheless, certain lenders may demand a personal guarantee from the borrower.
The Importance of Small Business Loans
Small business loans are substantial because they give entrepreneurs the capital they need to start or expand their businesses. This can help create jobs, drive innovation, and stimulate economic growth. Additionally, small business loans can help businesses weather unexpected financial challenges, such as a sudden drop in revenue or an unexpected expense.
Different Types of Small Business Loans
When securing financing for your small business, there are various types of loans to consider. Each loan type has its own requirements, benefits, and drawbacks.
Familiarizing yourself with the various kinds of small business loans on offer can aid in selecting the funding alternative that aligns best with your business requirements. Multiple types of small business loans are accessible, with the most prevalent ones being:
1. Term Loans
A term loan is a small business loan that provides a lump sum of money that must be repaid over a fixed period, usually one to five years. The repayment period is predetermined when the loan is approved, and the interest rate is fixed for the duration of the loan.
One of the primary advantages of term loans is their predictability. With a fixed repayment schedule, borrowers know exactly how much they must pay each month, making it easier to budget and plan for the future.
2. Lines of Credit
A line of credit is a versatile funding alternative for small enterprises, enabling them to utilize a predetermined amount of funds per their requirement. This implies that borrowers can access the funds when required instead of submitting a new loan application whenever they need additional capital.
Lines of credit operate differently from conventional term loans. Borrowers are authorized to a maximum credit limit to withdraw whenever necessary instead of receiving a lump sum at the outset.
3. SBA Loans
Small Business Administration (SBA) loans are a type of small business loan that the federal government partially guarantees. The SBA works with other lenders and banks to finance small businesses that may not qualify for traditional bank loans.
SBA loans are designed to fund small businesses with difficulty qualifying for traditional bank loans due to limited collateral or insufficient credit history. In addition, the SBA's guarantee of a portion of the loan reduces the risk to the lender, making it easier for small businesses to access financing.
4. Invoice Financing
Invoice financing is a funding option for small businesses that enables them to borrow money by leveraging their unpaid invoices. Rather than waiting for customers to settle their invoices, businesses can use invoice financing to easily access cash, bridging the gap between invoicing and payment receipt.
Invoice financing is relatively simple—a business sells its outstanding invoices at a slashed rate to a lender. The lender then disburses a percentage of the total invoice value to the business, usually around 80% to 90%. After the customer pays the invoice, the lender deducts the advance and fees and refunds the remaining balance to the business.
Options for Small Business Loans
Small business owners have various options for securing financing for their businesses. Each financing option has its own benefits and drawbacks, making it essential to choose the right choice for your business needs.
1. Traditional Bank Loans
Traditional bank loans are one of small businesses most common financing options. Banks offer a variety of loan types, including term loans, lines of credit, and SBA loans. While traditional bank loans may have strict eligibility requirements, they typically offer competitive interest rates and longer repayment terms.
2. Online Lenders
Online lenders have emerged as a prevalent funding alternative for small businesses. Online lenders provide a range of loan types, such as term loans, lines of credit, and invoice financing. Although online lenders might have lenient eligibility criteria than conventional banks, they typically levy higher interest rates and fees.
3. Alternative Financing Options
Alternative financing options are a broad category that does not fit the traditional bank or SBA loan categories. These may include crowdfunding, peer-to-peer lending, or equipment leasing. Alternative financing options may be more flexible than traditional ones but typically have higher interest rates and fees.
Small business owners have various financing options available to them—each has its own set of benefits and drawbacks, making it essential to research and choose the financing option that is best suited for your business needs.
Costs of Small Business Loans
Small business loans are a valuable resource for entrepreneurs, but the associated costs must not be overlooked. We're here to help decipher how interest rates, fees, and prepayment penalties can affect the total cost of financing your venture.
1. Interest Rates
Interest rates are one of the primary costs associated with small business loans. Interest rates may vary depending on the type of loan, the lender, and the borrower's creditworthiness.
Typically, the lower the borrower's credit score, the higher the interest rate they'll pay. Interest rates for small business loans can range from around 4% for SBA loans to 20% or more for some alternative financing options.
2. Fees
Besides interest rates, small business loans may come with various fees, including origination, application, and processing fees. These fees can accumulate quickly and significantly increase the overall cost of the loan. Therefore, it's essential to read the loan agreement carefully and understand all its associated fees before accepting it.
3. Prepayment Penalties
Some lenders may charge prepayment penalties if the borrower pays off the loan early. Prepayment penalties can increase the overall cost of the loan and make it more challenging to pay off the loan ahead of schedule.
Numerous factors can influence the total cost of a small business loan. These factors include the borrower's creditworthiness, loan term, loan amount, and collateral offered. Borrowers having a better credit score are typically eligible for lower interest rates and fees, whereas those with a lower credit score may incur higher rates and fees.
The longer the loan term, the greater the interest amount the borrower will bear. Moreover, loans with larger amounts or more valuable collateral may attract lower interest rates and fees.
Qualifying for Small Business Loans
Entrepreneurs must satisfy specific criteria to be eligible for a small business loan. Lenders usually have their own eligibility standards and criteria to evaluate loan applications. Here are some of the most prevalent prerequisites that small business owners need to meet to qualify for a loan:
- Good Credit Score. Having a sound credit score is vital for small business loans. Lenders rely on credit scores to assess the borrower's ability to repay the loan and its creditworthiness. Typically, a credit score of 600 is mandatory to be eligible for a loan. The minimum credit score can vary depending on the lender and loan category.
- Detailed Business Plan. Lenders need to assess the viability and potential of a business before lending them money. Therefore, entrepreneurs must provide a detailed business plan that outlines their business goals, target market, products and services, marketing strategy, and financial projections.
- Collateral. Certain lenders may demand collateral as security for the loan. Collateral can comprise equipment, real estate, or inventory that can be liquidated to reimburse the loan if the borrower defaults.
- Financial Statements. Lenders require financial statements such as balance sheets, income statements, and cash flow statements to assess the financial health of a business. These documents give lenders an overview of the business's revenue, expenses, and profits.
- Industry Experience. Lenders may also consider the entrepreneur's industry experience when evaluating a loan application. Entrepreneurs with relevant industry experience are more likely to be approved for a loan than those without.
Securing the necessary funding for your business is no small feat—but it can be achieved if you're prepared with a strong credit history, business strategy, collateral, and financial statements!
Experienced entrepreneurs will find that meeting these requirements paves their path toward loan approval and ultimately allows them to invest in their venture.
Take Your Business to the Next Level With Small Business Loans
Finding the right financing for starting or growing your business requires a combination of knowledge, research, and consultation from trusted advisors. As small businesses strive towards success and face the challenge of funding their business endeavors, you must explore all your options, understand qualifications and requirements, and weigh all related costs to make an informed decision.
By arming yourself with the financial information you need, you can make smart decisions that best fit your unique business needs—allowing you to take advantage of opportunities and maximize your chances of achieving success for your small business. Take your business to the next level with small business loans!
