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How Do Business Loans Work? For Small Businesses, For Startups

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How Do Business Loans Work? For Small Businesses, For Startups

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Understanding How Small Business Loans Work

What Is a Small Business Loan?

A business loan is a type of financing that  businesses can use to pay for expenses related to business operations, expansion, or acquiring an existing business. There are various types of business loans and lenders available to meet the needs of businesses. 

The most common sources of business loans are the Small Business Administration, banks, credit unions, online lenders, and fintech companies. Fintech companies can specialize in specific types of financing like equipment loans, purchase order financing, or accounts receivable financing.

Some loans may have spending restrictions while others may only require that funds are used for business purposes. Before taking out a business loan you should thoroughly understand the terms which can include repayment, fees, restrictions, and so forth. 

To qualify for a business loan, a business must meet or surpass the minimum qualification requirements that the lender may have. Some of those requirements include. .

  • Minimum personal and/or business credit score
  • Strong revenue and/or personal income
  • Minimum amount of time in business
  • Detailed business plan outlining how the business will use the funds and the results they expect from the additional investment cash

Being as prepared as possible can help expedite the business loan process as well as help you secure more favorable terms. At mySMBscore we can help businesses understand their ability to qualify for a loan. We equip business owners with actionable insights that can help them prepare and find the best business loan for their needs. Read on to learn more about business loans and how they work.

How Do Small Business Loans Work?

Most business loans work just like any other type of loan that you may obtain in your personal life. The type of loan will matter in regards to how the loan works. Here are some common types of business loans and how they work:

  • Term loans: Terms loans are funded as a lump sum that is repaid in installments with interest. Most term loans are fixed meaning the payment will be the same throughout the loan term. When the term is over the loan should be paid in full as long as all payments were made on time. Some term loans can have a variable rate which would cause payments to fluctuate. They can also require collateral in some cases. Term loans offer a flexible option for business owners that need access to a lump sum of cash for various expenses. 
  • Line of credit: A line of credit can help businesses that struggle with cash flow. Businesses that require inventory may struggle with cash flow as inventory is expensive to hold and funds are not always received the moment a sale is processed. A line of credit is revolving so you’d have access to a credit limit that you can draw on. You are only responsible to repay with interest the portion you draw. This is very similar to a credit card but on a much larger scale and with more favorable rates. A line of credit can be secured or unsecured. 
  • Credit card: Credit cards offer some decent perks, but should be avoided as a form of funding that a business relies on. They are best used as a way to track expenses and improve cash flow in the very short term. Business credit cards can have extremely high interest rates and if not careful, business owners can find themself in a cycle of debt. 

Keep in mind that secured business loans do pose a slight risk, although with a reward. Oftentimes they come with higher limits and lower rates, but if you default the lender can take possession of the collateral. Before taking a business loan, you should ensure that your business is financially stable and can handle the commitment. MySMBscore can help business owners evaluate the risk of a business loan. 

How does business loan repayment work?

Repayment terms can vary depending on the type of loan. Plus, some lenders may offer more flexibility than others in terms of repayment. 

  • Term loan: Most term loans will come with a fixed repayment schedule. This means that you will have a minimum payment due monthly that includes interest. If you make that payment every month until the end of the term, the loan should be paid in full. 
  • Line of credit: Compare this to a line of credit where repayment only occurs for the amount you draw. Furthermore, inventory loans may only require that you repay when inventory sells. 
  • Alternatives forms of financing: There are also alternative forms of financing such as accounts receivable financing like invoice financing. Accounts receivable financing usually only requires repayment when invoices are paid by customers. Another example is merchant cash advances. With a merchant cash advance, companies typically collect payments daily or weekly by receiving a predetermined percentage of credit and debit card sales. 

Understanding repayment terms is an important part of being a responsible and successful business owner. 

How does a small business loan work?

Small business loans work just like normal business loans. It depends on the type of loan that you get and who the lender is. Term loans through the SBA, banks, credit unions, and online lenders can provide you with an upfront sum of cash that you will need to pay back over time with monthly payments. Credit lines can give you a limit that you can borrow from as long as you continue to make the minimum payments each month. Accounts receivable financing options typically collect the entire amount once a customer pays their invoice for goods and services that your business fulfilled. When pursuing a small business loan, find lenders that are dedicated to helping small businesses. To prepare and connect with lenders, visit mySMBscore. 

How does a startup small business loan work?

Startup business loans work just like all other types of business financing. However, most often, startup business loans are going to require collateral to secure the loan. The collateral could come in the form of commercial assets like real estate, equipment, machinery, and vehicles, or personal assets like homes, vehicles, and other valuable personal property. Additionally, a startup business loan is likely going to require a well-thought-out business plan detailing how the money is going to be used and the expected expenses and revenues forecasted over 5 years.

In general, it's typically more difficult to acquire a small business start up loan. This is typically due to the business credit history of a startup company, among other reasons.

Start up business loans are similar to normal business term loans, however there are additional items to be aware of such as:

  1. Different Business Loans: Startups can access term loans, lines of credit, SBA loans, and equipment financing, each suitable for different needs. However, there may be higher interest rates and less loans to qualify for.
  2. Personal Credit History: Since startups lack business history, lenders often evaluate the entrepreneur's personal credit score and financial stability. If you’ve been in business less than 6 months it may be very difficult to acquire a business loan, even with a solid personal credit history.
  3. Higher Interest Rates and Varied Terms: Due to the higher risk, startups may face higher interest rates and diverse repayment terms. Lenders want to make sure startups can pay the loans back, it is an added risk they take on and therefore may have higher terms.
  4. Detailed Application Process: Applicants usually need to submit a comprehensive business plan, financial projections, and personal financial information.
  5. Collateral and Personal Guarantees: Lenders may require collateral and personal guarantees, making the entrepreneur personally liable if the business fails to repay.

What are business loans used for?

If you are applying for a business loan, you should have a solid business plan that includes how you intend to use the funds and what the anticipated results will be after putting the funds to work. 

Some of the most common uses of business loans include the following.

  1. Acquiring an existing business
  2. Business expansion
  3. Opening a franchise
  4. Startup expenses
  5. Commercial real estate purchases
  6. Working capital
  7. Purchasing equipment or machinery
  8. Purchasing inventory
  9. Renovations of commercial property
  10. Debt consolidation
  11. Marketing and advertising campaigns

Types of Business Loans

There are many types of business loans or commercial financing options available. Business loans can be obtained from the Small Business Administration, banks, credit unions, online lenders, and fintech companies. Here are some of the most common types of business loans.

  1. Conventional term loans
  2. SBA 7(a) loans
  3. SBA 504 loans
  4. Equipment financing
  5. Invoice factoring
  6. Merchant cash advances
  7. Business lines of credit
  8. Business credit cards
  9. Purchase order financing
  10. Equity-based financing
  11. Government grant programs

How Business Lines of Credit Work

A business line of credit is a revolving credit line that allows you to borrow up to a specific limit. You can borrow as little or as much of that limit as long as you continue to make the minimum payments. You are only charged interest on the balance that you carry over from month to month, and the amount you repay can be borrowed again at a future date. 

How do you qualify for a business loan?

To qualify for a business loan, you should have a good to excellent personal credit score, and if you have one, a good business credit score. Also, you are going to need to show that you have a good amount of business revenue and personal income coming in that can easily cover the loan payments. Aside from a good credit history and a strong revenue stream, lenders are going to want to see that you have a history of successful business experience and that you do not have too many other debt payments to make each month. 

To learn more about qualifications, visit mySMBscore for personalized recommendations. 

How hard is it to get a business loan?

As a business owner you’ll need to be prepared for a business loan. If you’re unprepared or not qualified, it can be extremely hard to get a business loan. So, how do you best prepare? Visit mySMBscore to start. We can provide an overview of your credit score and its components as well as what lenders are going to focus on. With this information you can either choose whether you are ready to apply for a loan and should qualify for ease or decide to invest time in preparing a bit more. MySMBscore can provide actionable insights that can help you get a better business loan.

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