As a small business, whether you’re just getting started or looking to secure additional capital to expand, it’s incredibly important to understand what kind of financing options exist. Before we dive into the different types of loans small business owners can leverage, let’s cover a couple foundational elements of borrowing money from institutional lenders.
What Can Small Business Loans Be Used for?
Small business loans fund a variety of needs! From launching a startup (equipment, inventory) to growing an established business (marketing, real estate), they cover essential expenses. They can also bridge shortfalls in working capital (covering costs until customer payments arrive). Think of them as a financial boost to help your business thrive.
How to Qualify for a Business Loan
Qualifying for a business loan involves convincing a lender you’re a good bet to repay. Here are some key factors to focus on:
- Solid Business Plan: Demonstrate a clear vision, strong market opportunity, and financial projections. This shows the lender you have a roadmap for success.
- Good Credit History: Both personal and business credit scores are important. A strong history assures the lender you handle debt responsibly.
- Profitability & Cash Flow: Prove your business can generate revenue and has a healthy cash flow to cover loan repayments.
- Collateral (Optional): For secured loans, offering valuable assets like equipment or property can improve your chances and potentially lower interest rates.
- Industry Experience: Experience in your field builds confidence that you understand the market and can navigate challenges.
By strengthening these areas, you’ll increase your chances of securing a business loan and securing the capital needed to grow your business.
What Goes into the Pricing of a Business Loan?
The price of your business loan boils down to two main factors: risk and cost. Riskier loans for the lender come with higher interest rates and fees. Here’s a breakdown of what lenders consider:
- Your Business & Creditworthiness: A strong business with a solid track record and good credit history translates to a lower risk loan for the lender. This means you’ll qualify for a better interest rate and potentially lower fees.
- Loan Type & Terms: Short-term loans with smaller amounts are generally less risky, so they may have lower rates. Conversely, long-term loans for larger sums involve more risk and may come with higher rates.
- Fees on Top of Interest: Beyond the interest rate, lenders may charge origination fees, application fees, and others. Be sure to factor these into the total cost of the loan.
Remember, the Annual Percentage Rate (APR) considers both the interest rate and fees, giving you a clearer picture of the loan’s true cost. By shopping around and comparing APRs, you can find the most affordable option for your business needs.
Unsecured vs. Secured Types of Business Loans
Deciding between unsecured and secured business loans depends on your priorities and risk tolerance. Here’s a quick breakdown:
Unsecured Business Loans
- No Collateral Needed: You don’t risk losing business assets like equipment or property if you can’t repay.
- Faster Approval: Generally easier and quicker to qualify for since there’s no collateral valuation.
- Higher Interest Rates: Lenders see unsecured loans as riskier, so they charge steeper interest rates.
- Lower Loan Amounts: Typically offered for smaller funding needs due to the higher risk for the lender.
Secured Business Loans
- Lower Interest Rates: By putting up collateral, you incentivize the lender and qualify for more favorable rates.
- Higher Loan Amounts: Secured loans can support larger funding needs due to the collateral backing the loan.
- Slower Approval: The loan approval process might take longer as the lender assesses the value of the collateral.
- Risk of Losing Assets: If you default on the loan, the lender can seize your collateral to recoup their losses.
In a nutshell:
- Unsecured is faster and easier, but comes with higher costs and limitations. Choose this if you need funds quickly and don’t want to risk assets.
- Secured offers better interest rates and larger amounts, but takes longer to secure and involves potential asset loss. This is ideal for larger funding needs and businesses with valuable collateral.
Different Types of Business Loans for Your SMB
1. Term Loans
Term loans are a lump sum of cash borrowed from a lender, repaid with interest over a set time (often 1-10 years). They’re popular for businesses as they provide predictable payments and lower rates than credit cards, allowing for investment in growth or equipment.
Pros:
- Predictable repayment schedule helps in budgeting.
- Typically lower interest rates for qualified borrowers.
- Large loan amounts can be secured, ideal for significant capital investments.
Cons:
- Requires a strong credit history to qualify for the best rates.
- May involve origination fees and prepayment penalties.
- Collateral might be necessary to secure the loan.
2. SBA Loans
SBA loans are government-backed loans for small businesses. They offer easier approval and potentially better terms than regular loans, helping startups and businesses that might not qualify otherwise.
Pros:
- Lower interest rates and longer repayment terms than many other loans.
- Small down payments and flexible overhead requirements.
- Variety of loan types to suit different needs, including 7(a) and 504 programs.
Cons:
- Lengthy and complex application process.
- Often requires collateral and a personal guarantee.
- Not all businesses qualify, especially newer or high-risk businesses.
3. Business Lines of Credit
Business lines of credit are like a credit card for your business. You get approved for a set amount but only pay interest on what you borrow. It’s good for ongoing expenses or unexpected needs. Unlike term loans, you can draw funds, repay, and redraw as needed, offering more flexibility but often with variable interest rates.
Pros:
- Only pay interest on the amount drawn, not the entire credit line.
- Flexibility to manage cash flow for short-term needs.
- Can be reused as it is repaid, making it a versatile funding tool.
Cons:
- Higher interest rates compared to traditional term loans.
- Possible fees for maintenance or non-use.
- Requires disciplined repayment to avoid debt accumulation.
4. Equipment Loans
Equipment loans are financing specifically for buying business equipment. They spread the cost over time with fixed payments, similar to a car loan. This frees up cash for other needs while the equipment you need generates profits. They often require a down payment and the equipment itself acts as collateral.
Pros:
- Financing covers most, if not all, of the equipment cost.
- Loan is secured by the equipment itself, reducing lender risk.
- Depreciation of the equipment can be tax-deductible.
Cons:
- Equipment becomes obsolete, but payments continue.
- Down payment may be required.
- Potential for equipment to be worth less than the owed amount over time.
5. Invoice Factoring
Invoice factoring is like selling your unpaid invoices for immediate cash. You sell invoices to a company at a discount, getting a quick advance (up to 90%). The factor collects from your customer and sends you the remaining amount minus their fee. It helps businesses with cash flow by turning waiting payments into working capital.
Pros:
- Immediate access to cash improves cash flow.
- Does not require extensive credit checks.
- Outsourcing collections saves time and effort.
Cons:
- Can be more expensive than traditional loans.
- Customers may have concerns about dealing with a third party.
- Loss of control over accounts receivable.
6. Invoice Financing
Invoice financing is like borrowing against your invoices. Unlike factoring, you don’t sell them. A lender advances you a portion (usually 70-80%) of the invoice value upfront, with interest. You repay them once your customer pays the full invoice. It provides faster cash flow without giving up control of collections.
Pros:
- Provides immediate working capital without waiting for invoice payments.
- Less expensive than factoring.
- You maintain the customer relationship and collections process.
Cons:
- Requires good invoicing practices and reliable customers.
- Often incurs fees and interest that can accumulate.
- Not suitable if invoices are frequently disputed.
7. Merchant Cash Advances (MCA)
Merchant cash advances (MCAs) are a shortcut to revenue. Instead of a loan, you receive a lump sum upfront. Repayment comes from a percentage of your daily credit card sales, plus a fee. It’s fast and easy to qualify for, but MCAs can be expensive due to fees, not interest rates.
Pros:
- Quick access to funds.
- Repayment aligns with sales, which is beneficial during slow periods.
- Minimal credit requirements.
Cons:
- One of the most expensive forms of financing.
- Daily deductions can significantly impact cash flow.
- Lack of transparency in terms and conditions.
8. Personal Loans for Business
Personal loans for business are like using a credit card for big-ticket items, but for your business. You borrow a set amount repaid with interest over months. It’s easier to qualify for than a business loan, but riskier. You’re personally liable and interest rates can be high.
Pros:
- Based on personal credit, which might be easier to qualify for.
- No restrictions on how the funds are used.
- Often unsecured, not requiring business collateral.
Cons:
- Risk of mixing personal and business finances.
- Typically lower loan amounts than business loans.
- Personal assets might be at risk if the business fails.
9. Working Capital Loans
Working capital loans are short-term cash injections for your business. They bridge the gap between your day-to-day expenses and incoming revenue. Think of them as an advance to cover payroll, rent, or inventory until customer payments arrive. They come in various forms like lines of credit or term loans, each with its own repayment terms.
Pros:
- Helps smooth out cash flow fluctuations.
- Short-term financing options can be quickly obtained.
- Often unsecured, which is advantageous for businesses without assets.
Cons:
- Higher interest rates due to the short-term nature.
- Only suitable for operational expenses, not growth or expansion.
- Frequent repayments can strain cash flow.
10. Business Credit Cards
Business credit cards are like company credit cards. You earn rewards on purchases and separate your business spending from personal finances. They offer convenience, potential for rewards, and can help build business credit. However, watch out for high interest rates and fees, and make sure to pay your balance in full to avoid debt.
Pros:
- Accessible credit for ongoing or unexpected expenses.
- Potential rewards and perks like cash back or travel points.
- Helps build a business credit history.
Cons:
- Higher APRs compared to other loans.
- Can lead to uncontrolled spending.
- Requires good credit management to avoid costly debt.
11. Microloans
Microloans are tiny loans, typically under $50,000, for starting or growing a small business. They’re ideal for bootstrapping or small needs. Managed by community lenders, they often come with mentorship and are easier to qualify for than traditional loans.
Pros:
- Accessible to businesses with little or no credit history.
- Lower borrowing amounts reduce risk of over-leveraging.
- Often accompanied by business training and support.
Cons:
- Limited funding may not cover all business needs.
- Often targeted to specific groups or industries.
- Might have higher interest rates compared to larger loans.
12. Commercial Real Estate Loan
Commercial real estate loans finance the purchase, construction, or refinancing of income-generating properties like offices, stores, or apartments.
Unlike mortgages, they focus on the property’s income potential. Lenders typically require a down payment and the loan itself has a shorter term than residential loans (5-20 years).
Pros:
- Long-term financing secured by real estate.
- Interest is generally tax-deductible.
- Enhances business asset portfolio.
Cons:
- Requires a significant initial investment.
- Risk of property devaluation.
- Approval and funding process can be lengthy and complex.
More about SBA Loans
What Is the Most Popular Type of SBA Loan?
The most popular type of SBA loan is the 7(a) loan program. It’s SBA’s primary program for small businesses, offering a wide range of uses and flexible terms for various business needs.
What Is the Easiest SBA Loan to Get Approved for?
The easiest SBA loan to get approved for is generally considered to be the SBA Express Loan, a subcategory of the 7(a) loan program. Here’s why:
- Simpler Application Process: Compared to other SBA loans, the Express Loan has a streamlined application with less paperwork.
- Faster Approval Times: You can potentially get approved in as little as two weeks, making it ideal for situations where you need funding quickly.
- Lower Loan Amounts: Express Loans are capped at $500,000, which can make them less risky for lenders and potentially easier to qualify for.
Remember that even with the Express Loan, eligibility requirements will still apply. So while it might be the easiest SBA loan to get, building a strong business case and having a good credit history will always be beneficial.
What Is the Difference between SBA 504 and 7a?
Here’s a breakdown of the key differences between SBA 504 and 7(a) loans:
Purpose
- SBA 7(a): More flexible for various business needs. Common uses include working capital, inventory, equipment, and even real estate.
- SBA 504: Specifically designed for fixed assets that promote business growth, such as purchasing land, buildings, or major machinery.
Loan Structure
- SBA 7(a): Traditional loan structure with a bank providing the entire loan amount.
- SBA 504: Three-party involvement:
- Bank finances 50% of the project.
- Certified Development Company (CDC) contributes 40% through a government-subsidized debenture (basically a loan with a low fixed interest rate).
- Borrower contributes a 10% down payment.
Down Payment
- SBA 7(a): Down payment requirements vary depending on the lender and loan purpose, but generally range from 10% to 20%.
- SBA 504: Requires a lower down payment of only 10%, making it easier on your cash flow.
Interest Rates & Fees
- SBA 7(a): Variable interest rates based on the prime rate and lender’s risk assessment. May also have origination fees and other closing costs.
- SBA 504: Fixed interest rates, typically lower than those on conventional loans due to the government involvement with the CDC debenture. Fees are generally lower as well.
Loan Term
- SBA 7(a): Loan terms typically range from 7 to 10 years, but can go up to 25 years for real estate.
- SBA 504: Offers longer loan terms, typically 20 years or even 25 years, making repayments more manageable for expensive fixed assets.
Approval Process
- SBA 7(a): Application process can be complex and may take longer due to a full underwrite by the bank.
- SBA 504: May involve a slightly simpler approval process due to the involvement of the CDC, which focuses on economic development.
Key Takeaways:
- Choose an SBA 7(a) loan for its flexibility if you need funding for various business purposes, including working capital.
- Go for an SBA 504 loan if you specifically need financing for fixed assets like property or equipment, and want a lower down payment, fixed rates, and longer terms.
What Disqualifies You from Getting an SBA Loan?
There are a few red flags that can disqualify you from getting an SBA loan:
- Business Ineligibility: Some business types are simply not eligible for SBA loans. These include businesses involved in illegal activities, speculation, gambling, or lending institutions like banks or finance companies.
- Weak Business Plan & Financials: An unfocused plan or shaky financials showing insufficient profitability or cash flow raise red flags for lenders. They need to see a clear path to success and your ability to repay the loan.
- Poor Credit History: Both your personal and business credit scores matter. A history of late payments, defaults, or high debt levels can make you seem like a risky borrower.
- Criminal Background: While not an automatic disqualifier, recent felony convictions or current involvement in legal issues can hinder your application.
- Unsatisfactory Collateral (if applicable): For secured loans, the collateral you offer (like property or equipment) needs to be valuable enough to cover the loan in case of default. If the collateral’s value is insufficient, it can jeopardize your approval.
If you avoid these pitfalls and present a strong case with a viable business, good financials, and a decent credit history, your chances of getting approved for an SBA loan increase significantly.
