Loans can be intimidating for a small business owner who’s new to the game. We know. There’s already enough stress to prepare and set up requirements on top of the finances!
But if done right, business loans can leverage either a new or existing business, whatever the financial situation.
That’s why we’re here. We did the research, so all that’s left for you to do is take notes, apply your insights, and succeed.
What is a business loan?
First things first, let’s define what a business loan means. It’s a commercial financing program offered by traditional banks, credit lenders, and lending institutions alike.
Once approved, you can use the funds for any business expense. Be it for your working capital, debts, or investments as long as it is within business operations.
Note that most often than not, lenders do not allow personal expenses to be part of the funding.
There are two kinds of financing – debts and equity financing.
- Debt: borrowing money and paying it back.
- Equity: when a shareholder invests assets into your business and expects an ownership percentage.
Business loans fall under debt financing.
How does money lending work?
The simplest step-by-step explanation would be:
- The borrower approaches a lending institution of choice to apply for a business loan.
- The lender reviews the business loan application, required documents, business history, etc., all subject to loan approval.
- Based on the application, the lender decides on the specifics such as payment plans, interest rates, and loan amounts.
- The borrower must repay the money according to the agreed arrangements and duration.
The process for small business loans is easy. The confusion comes in when technicalities come into play.
As a borrower, it helps to understand the business terms to avoid bad debts.
Types of business loans and how they work
There are several business loan types. Different institutions may offer other packages depending on where you apply. Here are some of the most common classifications.
Working capital loans
These are short-term loans used to sustain day-to-day business finance such as employee payroll and operational expenses. Seasonal companies that don’t expect regular income typically opt for this.
Some examples of working capital loans are:
- SBA loan
- A business line of credit
- Short-term loan
The defining factor of a term loan is that you get the lump sum money all at once.
You need to repay over a specified duration through monthly payments or instalments agreed upon at the beginning of the loan term.
There are short and long-term loans. You can get a business loan suitable for your needs depending on what you applied for.
There are also term loans for long-term investments or significant expenses. If your business finances are stable and consistent, this is a good choice.
The interest rate is low, the repayment increments make it lighter on the pocket, and you get the funds at once.
Here are some examples of term loans:
- Personal term loans
- Startup loans (for startup costs)
- Business mortgages
Business lines of credit
If term loans can get you the whole loan amount at once, this one lets you borrow on credit. You need to repay the amount after the term expiration, typically within 1 to 2 years.
What’s great about a business line of credit is that it’s flexible.
If you’re a business owner still unsure how much cash flow you need, you can apply for a credit line and only pay for the amount you used.
The interest rate is also based on the borrowed credit amount only.
However, a business credit card and a business credit line differ in such that the latter’s line of credit has an end.
The expiration signals the repayment period, and you can no longer borrow money during this time.
Bigger businesses can apply for an overdraft facility, which allows them to spend beyond the limit.
Merchant cash advance (MCA)
If you need cash upfront, an MCA lender can give you the amount immediately.
Owners typically opt for this during urgent situations and when a traditional lender rejects their application.
MCAs are expensive with a 1.2 to 1.5-factor rate given the immediate funds (i.e., borrowed $10,000 x 1.5 = $15,000 total).
MCAs are an excellent option for businesses with a stable cash flow and income but just so happen to have an emergency.
Since it’s expensive and the amount doubles quickly, ensure that you can pay off the loan.
Invoice financing or factoring
It’s a type of financing that lets your business sell outstanding invoices to the lender.
In easier words, you can borrow the amount you’ve issued to your customers using an invoice system.
You pass on the collection responsibility to them. You, in turn, receive an advance of the projected amount. The catch is that there are factoring fees and rates.
Secured loans vs. unsecured loans
You’ll also encounter these two terms often as you venture into business loan applications.
A secured loan requires you to have collateral upon borrowing the money.
Lenders will have the security of repossessing or selling the debt if you fail to repay it within the agreed period.
It’s usually the traditional lenders or a traditional bank loan that requires security. Examples of collaterals are car titles, real estate, investment shares, etc.
Unsecured business loans don’t require you to pledge collateral.
Some only need you to sign a personal guarantee but expect the business loan interest rates to be higher in some cases.
There are now a lot of institutions offering unsecured loans, making it easier and more convenient to apply for a small business loan.
Business loan requirements
Like any other type of loan application, there are requirements to fulfil. It will differ from one lender to another, but here are the standard documents.
Lenders want to know your business’s structure, overview, and plans. It’s crucial to understand your standing and how much money you need.
A new business especially needs a business plan to explain the venture and earn the lenders’ trust. Companies with more prolonged operations can get better packages.
Financial status and minimum credit score
Lenders may ask for both your personal credit score and business credit score. It gives them an overview of your financial history to know how you deal with debts and loans.
In most cases, low personal credit scores won’t hinder you from getting a loan but expect a higher interest rate.
For some, they set minimum scores required for each loan package that you have to meet.
They also check how much you earn vis-a-vis your existing debts, revenues, and everything related to financial standing.
What are angel investors and venture capitalists?
An angel investor is typically a wealthy individual who invests in small businesses and startups to support them.
A venture capitalist pools and collates funds from different investors to serve as a business’ capital.
They are not business loans but likewise serve as business lending sources for small businesses.
Are online lenders better?
Many people prefer an online lender because of the swift process and less strict qualification system.
However, we suggest doing thorough research before pushing through with online lenders.
Is it hard to get a business loan?
As long as you’re qualified and can prove your ability to pay, it shouldn’t be hard to get lenders’ approval.
It only becomes a problem when your records show notorious debts. But even so, you still have a chance to acquire funds only with higher interest rates or shorter terms.
Starting your own business and taking care of serious finances such as loans can be daunting.
But with proper understanding, you can easily use these technicalities to fast forward your business.
Let us be your business advisor and learn more about small business loans from Lumi.