June 6, 2022
Adam Hoeksema
When you're starting a business, there are many things to think about. One of the most important decisions you'll make is how to finance your company. Several options are available, but one of the most popular is business loans. Business loans can help you finance a new project, expand your business, or cover other expenses. But how do business loans work? What can you do to increase your chances of approval? In this article, we'll explain how business loans work and give you some tips on how to increase your chances of approval.
What is a business loan?
A business loan is a loan given to a business rather than an individual. The loan terms will vary depending on the lender, but typically, you'll be expected to repay the loan within a few years. Businesses can borrow loans for various reasons, including, but not limited to, renovations and improvement, staffing, and expanding their business.
How do business loans work?
Business loans work by providing the business with the funds they need to cover their expenses. The terms of the loan will vary depending on the lender, but typically, you'll be expected to repay the loan within a few years. In some cases, you may be required to provide collateral, such as property or equipment, to secure the loan.
How to qualify for a business loan
Whether it's a private business loan or a bank loan, there are several things that you need to do to qualify for a business loan. These include having the proper documents as well as a great credit score. Here's a breakdown of how to qualify for a business loan:
Have a business plan
Most lenders require you to have a business plan. Business plans have various benefits to financial sources including helping them ensure that you have a clear idea of how you will use the loan and how you plan to make repayments. Most generally, a business plan needs to include financial projections so you can demonstrate how you plan to repay the loan you are taking.
Make sure that your business plan clearly explains what your company does and how you make money from your business. Also, ensure that it identifies your competitors, your plan to stay above them, and your target market.
Your business plan should also include financial projections for your company. This will help the lender see how much money you're likely to make in the future and whether or not you're a good candidate for a loan.
Decide the type of business loan you want
There are various types of business loans that you can take depending on the type of business and financial help you need. Some loans, such as SBA loans, have higher interest rates than other loans but may be easier to qualify for. Choose the loan that best suits your business needs.
Prepare your financial documents
When you apply for a loan, the lender will want to see some financial documents. These documents will help the lender understand your financial situation and see if you're a good candidate for a loan. Additionally, the documents will help establish if you're creditworthy and can repay the loan.
The documents that every lender will need are:
- Your identification: shows the lender who you are. They will need to see a government-issued ID, such as a driver's license, passport, or state ID card.
- Your income documentation: proves to the lender that you can repay the loan. Documentation can be in the form of pay stubs, tax returns, or other financial documents.
- Your asset documentation shows the lender that you have the collateral to back up the loan. This can be in the form of a house, car, savings account, or other assets.
- Your credit history: gives the lender a sense of your creditworthiness. They will look at your past borrowing and repayment history to see if you are a good risk.
Have a strong credit score
Your credit score is one of the most important factors lenders consider when approving loans. A strong credit score shows that you're financially responsible and are more likely to repay the loan on time.
Typically, a strong credit score ranges from 700 to 850. There are a number of things you can do to improve your credit score, such as paying your bills on time and maintaining a good credit history. If you don't have a strong credit score, there are still options available, such as government-backed loans.
Be realistic about the amount you're asking for
When applying for a loan, be realistic about the amount of money you're asking for. Lenders are more likely to approve your loan if it's for a smaller amount and you have a strong repayment plan.
Research different lenders
Not all lenders are the same. Some may have higher interest rates, while others may be more lenient with their requirements. It's important that you research different lenders to find the best one for your needs. We shared some secrets about the top business lenders during a recession here.
You can also try using a business loan calculator to see how much you can borrow and what your monthly repayments would be. This can help you compare different lenders and find the best one for your business.
Be prepared with collateral
To secure the loan, some lenders may require you to provide collateral, such as property or equipment. This is to protect the lender in case you default on the loan.
Although putting up collateral is risky, it can help you secure large loans and lower your interest rates. Before deciding which property to put up as collateral, remember that the lender may come after that property if you fail to repay the loan.
Get professional help
Work with a reputable company like ProjectionHub to get various templates for financial plans and projections required for business loans.
We can help you understand what lenders are looking for and how you can improve your chances of getting approved for a loan. Our financial templates are not only easy to use but also industry-specific. Additionally, your templates will be reviewed by experts who make accurate projections and display them in an easily digestible and standard format that all types of lenders can interpret.
Types of business loans
In case you're wondering which business loan is best for your business, here are the most common types of business loans. Each loan has its pros and cons explained to help you make the best decision for your business.
- Term Loans
This is the most common type of business loan for small businesses. A term loan is a lump sum of cash that you borrowed and agreed to pay back over a set period, usually between one to five years.
Often, the interest rate of term loans is fixed. The repayment terms vary from lender to lender, so make sure to shop around to get the best deal.
Pros and cons of term loans
One of the biggest advantages of term loans is that they can be used for various purposes. Whether you need to finance inventory or buy new equipment, term loans can help.
Another advantage is that term loans usually come with fixed repayment terms. This means that you'll know exactly how much you need to pay each month, making it easier to budget and plan for the future.
However, one of the downsides of term loans is that they often require collateral. If you can't repay the loan, the lender could take your assets as payment. For this reason, it's important to carefully consider whether you can afford the monthly payments before taking out a loan.
Another downside is that term loans can be difficult to qualify for if you have bad credit. Lenders will often require collateral, such as your home or business, to offset the risk of lending to you.
Overall, term loans are a good option for businesses that need a lump sum of cash for a specific purpose. However, make sure you can afford the monthly payments and be aware of the risks before taking out a loan.
- SBA Loans
SBA loans are loans are backed by the Small Business Administration, a government organization that helps small businesses.
The SBA doesn't lend money directly to businesses. They use SBA-approved lenders like conventional banks to lend the money. That said, the SBA guarantees a portion of the loan. If you default on the loan, the lender will still get their money back.
Because of this guarantee, lenders are more willing to loan small businesses. However, SBA loans can be more difficult to qualify for as one must get approval from the lending institution and the SBA. Once approved, you can get amounts ranging from $500,000 to $5.5 million.
There are various SBA loans that your business can get, including:
- Express loans: These loans are for businesses that need a quick infusion of cash. The approval process is fast, and you can get up to $350,000.
- Special purpose loans: As the name suggests, these loans are for specific purposes like real estate or equipment purchases. Amounts and terms will vary depending on the loan.
- CDC/504 loans: These are long-term loans typically used for major expenses like real estate or equipment. The terms can be up to 25 years, and you can borrow up to $5.5 million.
- Microloans: Microloans are small loans that are typically under $50,000. They have shorter repayment terms than other SBA loans, usually seven years, with interest rates ranging from 7% to 9%.
Pros and cons of SBA loans
The biggest advantage of SBA loans is that they're easier to get than other loans. This is because the government guarantees a portion of the loan, so lenders are more willing to give you the money you need.
Also, if your business does not qualify for traditional loans, you can apply for an SBA loan. There are various resource centers available to help you with the application process.
One of the downsides of SBA loans is that they often have higher interest rates than other loans. This is because the government guarantee makes them less risky for lenders.
Another downside is that SBA loans can be difficult to qualify for. Lenders will often require collateral, such as your home or business, to offset the risk of lending to you.
Overall, SBA loans are a good option for businesses that need a loan but may have trouble qualifying for one. However, be aware of the higher interest rates and the difficulty of qualifying before taking out a loan.
- Invoice Factoring
Invoice factoring is a type of financing that allows you to sell your unpaid invoices to a lender in exchange for cash. It is an excellent business loan option to take if you need financing as you wait for customers to pay their debts.
Once a factoring company buys your invoices, the lender will give you a portion of the invoice value, typically around 70-90%. Then, once your customer pays the invoice, you'll get the balance minus a fee.
Pros and cons of invoice factoring loans
Factoring is a good option for businesses that need cash quickly but don't have the best credit. This is because it's not a loan, so there's no borrowing and no interest to pay.
Additionally, factoring requires no collateral, so it's a good option for businesses that don't have any assets to use as collateral.
The downside of factoring is that it can be expensive. The fees charged by the lender can be around 15%, which means you'll only get 85% of the value of your invoices.
Also, if you factor in too many invoices, you may have trouble getting new financing in the future. Lenders will see that you're relying on invoice factoring and may view you as a high-risk borrower.
Invoice factoring is a good option for businesses that need cash quickly but don't have the best credit or assets to use as collateral. However, it can be expensive and may limit your ability to get future financing.
- Private business loans
A private business loan is loan given by non-banking lenders. A non-banking lender can be a friend, family member, angel investor, or venture capitalist.
These loans can be easy to qualify for compared to other loans because the criteria are often less strict. For example, a private lender may only require that you have a minimum credit score of 580.
Pros and cons of private business loans
Lenders require less documentation compared to traditional lenders. Therefore, the application process is shorter, and you can get the money you need more quickly.
Another advantage of these loans is that they often have flexible repayment terms. For example, you may be able to choose a weekly or monthly repayment schedule.
The downside of private business loans is that they often have higher interest rates than other loans. This is because they are considered to be high-risk loans.
Additionally, private lenders may require collateral to secure the loan, such as your home or business.
Private business loans can be a good option for businesses that need financing quickly and have trouble qualifying for traditional loans. However, be aware of the higher interest.
- Equipment loans
Equipment loans are loans used to finance the purchase of equipment for your business. Equipment can include machinery, vehicles, or office furniture.
Not every business requires this type of business loan. If running your business relies on equipment, this loan is necessary for you.
Pros and cons of equipment loans
Equipment loans often have lower interest rates than other loans because the equipment serves as collateral for the loan.
However, if you default on an equipment loan, the lender can repossess the equipment. This could leave your business without the equipment it needs to operate.
Additionally, equipment loans typically have shorter repayment terms than other loans. This means you'll need to be prepared to make larger monthly payments.
- Business lines of credit
This type of business loan gives you access to a set amount of funds that you can use as needed. You only pay interest on the money you borrow, and you can typically choose when and how much to borrow.
Pros and cons of business lines of credit
Business lines of credit have a few key advantages. First, they're easy to qualify for if you have good credit. Second, they offer flexible repayment terms, so you can choose when and how much to repay.
The downside of business lines of credit is that they typically have higher interest rates than other loans. Additionally, if you don't repay the full amount you borrowed, you may be charged a fee.
- Short term loans
These are ideal for businesses that need cash quickly and can repay in less than three years. Short-term loans can help your business access funds in less than one day.
Usually, for such loans, you can borrow up to $500,000. To qualify for a short-term loan, your business must have been operational for at least six months and have a minimum monthly revenue of $12,000.
To secure the loan, you'll also need to provide collateral, such as equipment or inventory.
Pros and cons of short term loans
Short-term loans offer several advantages. First, they're easy to qualify for if you have good credit. Second, they offer flexible repayment terms, so you can choose when and how much to repay.
The downside of short-term loans is that they typically have higher interest rates than other loans. Additionally, if you don't repay the full amount you borrowed, you may be charged a fee.
If you were asking yourself how do business loans work, we hope this article has helped. Your business can take different types of loans to help improve operations, each with its own pros and cons. If you have a low credit score, go for a private business loan from a friend, family member, or a non-banking lender. Ensure that you have all the documents discussed above ready to increase your chances of getting your loan requests approved.
If you're in need of financial projections for a business loan application (which you will definitely need for a startup, acquisition, or expansion) check out our 60+ industry specific projection templates here.
