How Do Small Business Loans Work

Small businesses have often been described as the backbone of the American economy. According to the U.S. Small Business Administration (SBA), they’ve accounted for 62% of net new job creation since 1995, and make up nearly half of the private workforce in the United States. 

For startups and small businesses alike, small business loans can be a lifeline when it comes to financing new equipment or sourcing the supplies you need to make your company run. 

So how do small business loans work? Understanding how to you can get approved for a small business loan is much easier when you’ve done your research and become familiar with the options available to you. It’s important for small business owners and managers to develop an understanding of how business lending works, the different types of small business loans, the lenders offering them and some of the costs involved with loan repayment. 

A small business loan is a type of commercial financing that qualified businesses can obtain from traditional lenders like banks, or non-traditional lenders such as online lenders or credit unions.

This type of loan can be used for many different purposes, but the borrower must let the lender know what the money is to be used for when they apply. Some common uses of the capital from a small business loan include covering the cost of starting or acquiring a business, commercial real estate purchase or remodeling, cash flow, debt consolidation, purchasing equipment or inventory, finding a business expansion or providing the money to meet other short-term obligations while you get your business up and running.

In general, business lenders will not allow you to use business loans to cover personal expenses like a home, vehicles for personal use or other items unrelated to the needs of your business. Regardless of the type of loan you receive, paying the loan back on time should be a top priority to preserve your personal credit and protect any assets you may have had to put up as collateral.

Every small business owner should be familiar with the different business credit options available, some of which are:

Qualifying for a business loan involves several important factors. By understanding your lenders’ minimum requirements, you can work to increase your chances of qualifying for a small business loan. Most lenders require borrowers to meet certain benchmarks, which may include a minimum credit score, annual revenue and years in business. 

Even though the money you’re borrowing for your business will not be used for personal expenses, potential lenders use your personal credit score as a measure of your creditworthiness. The higher your credit score, the less risky it is in the eyes of the lender to lend you money. A score of 700 or above is considered good, while a score of 800 or higher is excellent. Free copies of your credit reports can be obtained from the major reporting bureaus – Experian, TransUnion and Equifax. 

If you’re starting up a new business, getting a loan may be more challenging because many traditional lenders require you to be in business for at least two years. This is where non-traditional financing, like a short-term loan from an online lender, might be a viable alternative.

Some lenders will require you to provide collateral such as real estate, business inventory or equipment to secure the small business loan. If you’re concerned about losing assets or don’t have any, an unsecured loan might be an attractive option, but may come with less-attractive repayment terms, like a higher interest rate or fees.

The process starts with being realistic about your business’s ability to obtain financing and the various types of loans for which you might qualify. According to the Forbes Advisor website, the process of obtaining a small business loan can be broken down into five steps:

Do you need money for expansion? For day-to-day operating expenses? To purchase new equipment or expand your shop? If so, one or more of the different loan types described earlier should suit your needs.

Different lenders have different minimum eligibility requirements and loan terms. Know your credit score and the impact it can have on your eligibility. How long have you been in business and how much revenue has your business generated over the last three years? Take some time to think about your finances and look carefully at your business’s income and cash flow to determine how much you can afford to apply to loan payments each month.

There are several places where you can find small business financing, including online lenders, traditional banks, credit unions and microlenders. Compare lenders by looking at their Annual Percentage Rate, or APR. APR is a good way to measure the total cost of a business loan because it includes calculations for all loan fees in addition to the interest rate. Other factors, like how quickly you can have the money, may also come into play with small business loans. 

If you lack collateral and time in business but need funding quickly, an online lender could be an option. If you’ve been in business for at least two years, have good credit and can wait longer to get the cash, a business loan from a traditional lender like a bank or credit union might be a better option. Traditional lenders typically offer term loans, lines of credit and commercial real estate loans at lower interest rates than online lenders. If you have bad credit, no credit history or are new in business, microlenders – nonprofits that typically make short-term loans of less than $50,000 – may be interested in working with you.

You’ll need various legal and financial documents to complete your loan application. Typically, these may include:

Once you’ve done your homework and submitted your application, you’ll have to wait for an approval. If your small business loan is approved, the lender will send you an agreement to sign before issuing you the funds or opening a business line of credit you can draw from.

Obtaining small business financing begins with the borrower having a basic knowledge of the fundamentals of business management. The business owner should have the demonstrated ability to run a profitable business and put together a strong business plan to present to lenders. Small business owners should conduct extensive research to determine what types of business loans are appropriate for their needs and which loan type might be the best option for them.