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As a small business owner, you may well find yourself in need of business financing options at some point in your journey. In general, only have their financing needs met. Sooner or later, you’ll find yourself wondering, how do business loans work?
Small Business Loan Definition
Small business loans provide business owners with access to funds that would otherwise be unavailable. The specific terms of the loan, interest rate, and monthly payments will vary depending on the specific lender.
There are a variety of business financing options—from short-term loans to business lines of credit. Each business loan has a unique set of criteria that you must meet to qualify for. In addition to considering what the loans require for approval, each lender will have their own requirements.
Traditional and alternative lenders consider factors such as credit history, working capital, and the length of time in business—among many other factors—to determine which type of business loan you may qualify for.
How Does a Small Business Loan Work?
The answer to how business loans work may be different for each business owner. Due to the evolution of lending and the growing popularity of online lenders, it is crucial for business owners to understand how business loans work.
There are many different types of business loans, but they all have a few features in common:
- Principal amount – The amount you borrow
- Interest rate – The cost of borrowing (fixed or floating rate)
- Repayment* – The amount you pay back
- Collateral or security – Assets used to secure the loan
- Loan term or repayment period – How long you have to repay the loan
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Call-out/Tip *NOTE: ‘Repayments’ are specific to loans, but if you decide a merchant cash advance makes more sense for your financing needs, you will need to make remittances. Learn more about . |
Whether you go for a ‘traditional loan’, like a term loan or another product, like a merchant cash advance, you’ll find these elements stay the same. Of course, every financing option is different with its own unique requirements.
Understanding the different types of business loans and financing options available will help you make the .
How To Make Business Loans Work for You
Before you get into what type of financing best suits your circumstances and needs, you need to know how you can make best use of a loan.
1. Consolidate Your Debt
Debt consolidation is a way of consolidating multiple debts into one outstanding amount. Instead of having to manage different loans and lines of credit, you just need to make one payment.
Other than being a lot easier to manage, consolidated debt can reduce how much you need to pay too. For instance, a term loan will have much lower interest rates than, say, a line of credit or a business credit card.
2. Expand the Business
Struggling to save up for the big investments your business needs to grow? Whether you need to purchase new equipment, add a location, or stock up on inventory, small business loans are the answer.
They can give your business the vital capital injection it needs to take the next step. Financing options such as equipment loans are particularly suited for this. They are secured against the equipment you procure, reducing risk for you and the lender.
3. Reduce How Much Tax You Have To Pay
The interest you pay on a small business loan is deductible as a business expense.
Not all business loans are eligible though; the Internal Revenue Service (IRS) will want to see that:
- You borrowed the loan from a professional lender, not family or friends
- The business is liable to pay off the debt
- You and the lender have a common understanding that the debt will be repaid
Call-out/Tip
The interest on most small business loans can be shown as a taxable expense. The IRS just doesn’t want people ‘loaning’ money to friends and family solely for the purpose of avoiding tax.
4. Resolve Cash Flow Problems
Poor liquidity—that’s a constant headache for most businesses in their early years (and for many mature businesses too). Working capital is essential for the survival of the business. After all, you need to pay suppliers and employees to keep the business running.
Small business loans are a great way to fill in the cash flow gaps, and reduce the cyclical worries about how you’re going to meet payment dates.
5. Build a Strong Credit Score
If your business doesn’t start building a credit history today, it’ll be difficult to get funding tomorrow. Small business loans don’t just provide capital to a business, they also show that a business is capable of taking care of its liabilities.
By taking out small loans (even if you don’t strictly need the capital right away), you can start to build a strong credit history for your business.
6. Establish Lender Relationships
Lending is based on a system of trust. Credit histories, background checks, P&L statements all do one thing—they establish that you, the borrower, will fulfill your commitment to repay the loan.
When you work with a particular lender often, the two of you build a relationship. The lender knows you are good for the money—making your access to financing easier.
How Does a Business Loan Work and Your Options Compared
Merchant Cash Advances (MCAs)
Merchant cash advances are an excellent option for businesses with lower credit scores and revenues that fluctuate. The remittances are based on your daily revenue, which helps prevent you from borrowing more than your business can afford.
- Do not require personal collateral to secure financing
- MCAs are easy to qualify for, and payments are made automatically every time customers make credit card payments (no monthly repayment schedule)
Business Term Loans
This type of short-term loan provides the borrower with a lump sum of funds. With term loans, you pay interest on the loan amount borrowed based on the business loan terms.
- Ideal for stabilizing cash flow to meet short-term needs
- Relatively low requirements mean loans are accessible to a lot of businesses (minimum credit score of 500, in business for 6+ months, $15,000+ in monthly bank deposits)
Small Business Administration (SBA) Loans
SBA loans are privately funded but backed by the federal government, who guarantees up to 80 percent of the loan amount. SBA loans tend to be more challenging to qualify for because of their more demanding requirements.
- Can provide lower interest rates and longer repayment periods compared to what you would find on your own
- (minimum credit score of 620, 2+ years in business, no outstanding tax liens, foreclosures, or bankruptcies in past three years)
Business Lines of Credit
A business line of credit provides revolving credit and flexible, on-demand business capital. Unlike term loans, a line of credit allows the borrower to access funds on-demand, pay back the amount borrowed, and draw credit again.
Business lines of credit are an excellent option for business financing because you can access funds when you need them—without paying for what you don’t use.
- Business lines of credit help you take control of how you borrow while building a
- Unsecured lines of credit do not require collateral
Equipment Loans
These allow you to purchase cutting-edge equipment needed to operate your business. Equipment loans can help your business innovate and modernize to evolve in your specific industry.
- Grow your business to meet rising demand and enter new markets
- Like a car loan, the equipment you purchase serves as the collateral for the loan (take caution that the loan term isn’t longer than the lifecycle of the equipment)
Invoice Factoring and Invoice Financing
, invoice factoring and invoice financing provide funds upfront on qualifying unpaid invoices. Instead of waiting 30 or 60 days for a customer to pay an outstanding invoice, these options give you access to funds immediately.
- Save time and effort following yo with customers for unpaid invoices
- You don’t have to make a fixed monthly payment or provide collateral towards the loan, unlike many other financing options
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Personal Loans
These also fall into the category of term loans. Typically, personal loans are more challenging to qualify for when the borrower .
- Excellent option for startups that don’t have a business history
- You aren’t required to demonstrate the business’s credit history (there likely isn’t any), monthly revenues, or collateral
Business Credit Cards
These can be a viable alternative to seeking a traditional business loan. Similar to a business line of credit, business credit cards offer a revolving line of credit. That said, the interest rates on credit and transaction fees can add up quickly, making business cards an .
- Good way to build a credit history for your business
- Don’t require collateral
How Do Small Business Loans Work in Your Favor?
How small business loans work varies based on your specific business, industry, and financing needs.
For example, a working capital loan may perfectly satisfy the needs of a small business that may have gone through a difficult month. However, this type of loan would likely not be the best solution for a small business seeking capital for expansion or significant real estate acquisitions.
A small business that needs cash flow to cover operating expenses, such as payroll or commercial rent and utilities—may need funding in days versus weeks.
Traditional lenders, like big banks or the SBA, typically have longer and more rigid application processes (that cannot look beyond balance sheets), which leads to delayed approval. When you need cash fast, the potential for same-day approval could mean the difference between meeting payroll obligations—or losing employees.
When you understand how small business loans work, you have the power to make an informed financial decision for your business. It is hugely beneficial for small business owners to have different lending options available.
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