How Does a Small Business Loan Work?
See Your Loan Options
Small business owners will inevitably find that at some point they need additional capital—be it for an expansion project or even just to boost cash flow. With a small business loan, lenders will disburse funds to the company and the borrower will then pay it back. How they pay back the loan will most often depend on the type of financing they've received. In this article, we look at how small business loans work and the various type of funding solutions that exist.
The Basics of a Small Business Loan
Depending on the type of loan you get, you will have set terms associated with repayment. From interest rate to the length of the payback period, these are determined by a few different factors, not the least of which is your company credentials. That is to say, credit score, length of time in business, available collateral, and annual revenue will all be considered by a lender when deciding whether you qualify and if so, what terms might apply.
As far as how a business loan works specifically, again that will rely heavily on the kind of loan for which you are applying. They all have very specific requirements and terms associated. So let's look at a few of the more common business loans out there.
This is without question the most common form of business loan. It's a lump sum payment that you then begin paying back usually on a month to month basis. Although with some shorter-term loans, you might be looking at a weekly or even daily payment.
Term loans, versus some of the other we will look at, can involve larger loan amounts. Anywhere from 25k to over a million depending on the approval process. And with term loans, repayment can range from 6 months for short term to up to ten years for some longer-term loans.
As far as the associated interest rates, this again will depend on a combination of factors to include your FICO and ability to secure the loan. So for instance, if you can pledge assets to back the loan, your rates will likely be lower as some of the risks are reduced.
This is one of the easier business loan types to qualify for. Largely this is because the equipment being purchased becomes instant collateral on the loan. So if you do default, the lender will most likely take back the equipment and try to recover its losses that way.
As the collateral is on hand, most often a lender will do 100% financing on an equipment loan, so you do not have to come up with a down payment. As far as the life of the loan, you want to think carefully about the kind of equipment you're purchasing. If throughout repayment, the equipment becomes obsolete, you're essentially just stuck with it. Interest rates on equipment loans tend to be lower and this again is because some of the risks are mitigated.
If a company has outstanding invoices, then invoice financing could be an option. Invoice financing entails a lender loaning you up to 90% of your outstanding invoices. Those invoices, therefore, become a type of collateral on the loan—so there is again less risk here.
That said, this type of loan product often has lower interest rates; such rates come in the form of factor fees. This means that for every week for example that an invoice goes unpaid, you may get charged a 1-3% factor fee on the unpaid amount. Once an invoice does get paid, you receive the remaining ten percent minus fees.
Also incredibly popular, SBA loans can be a bit harder to get approved for. They are though quite affordable and come with longer repayment terms. The SBA loan is a loan backed by the SBA up to a certain percentage. A borrower would work with a qualified lender. The lender will then seek a guarantee from the SBA for usually up to 85% of the loan value. If the applicant defaults, the SBA would then pay out the remaining amount to the lender.
There are a few different types of SBA loans with amounts ranging from 5k to five million. And the repayment period can be as long as 25 years in some cases.
Business Lines of Credit
A line of credit is an easier form of business financing to get. A business is approved for a total amount. However, they can draw out only what they need. They then only pay interest on the amount borrowed. Once they repay that, the money is again there for them to use. In some ways it's like a credit card, but with a lower interest rate and higher borrowing amounts.
Generally, business lines of credit can go from as little as 10,000 to over a million. As far as the duration of the line, this can be anywhere from six months to up to five years in some cases.
Merchant Cash Advances
With a merchant cash advances, a lender is loaning you money based on future credit card sales. That is to say, after reviewing your sales history, they will approve you for a certain amount to be paid out in a lump sum. You will then pay this back with a percentage of your credit card transactions. Ultimately, they are advancing you the money based on predicted revenue.
Most often the lender will integrate technology into your point of sale system so that a portion of each transaction goes to them. This is a relatively convenient way to work. Not to mention, when your sales are down you are paying less and when sales are up you pay more toward the loan. The daily payments continue (with interest/) until the total amount is paid back.