How do Business Loans Work?
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Each business owner needs to start somewhere. Funds are necessary to launch a new business. And knowing how to acquire those funds is vital to start on the right foot. Here we explore how business loans work, the different types of business loans and lenders, and how to apply.
By Lora Korpar
Small business owners have a lot to consider when starting an organization — from location to employees to marketing. But before they can think about that, they need funds to launch their business.
Business loans are crucial to starting a new company. You can’t begin anything without the funds. And though some can fund businesses using money from savings and loved ones’ assistance, not everybody has the option to bootstrap their company. Established companies can also benefit from business loans.
Many loan options exist, so it is important to pick one that meets your needs. So how do you choose the right loan for you? Then, how do you obtain it?
I spoke with Daniel Dias, owner of Small Business Lending Source, plus Mike Wright, a managing member at Foresight Business Funding, LLC, to discuss how business loans work, types of business loans and what to know before applying for one.
Why People Seek Business Loans
Having extra funds available is important when starting and maintaining a small business. Wright said having extra cash can provide leverage and security.
“Eventually you'll have a dip in cashflow or an emergency, so it's best to be prudent and plan ahead,” Wright said. “So if you can get a good loan at a good rate or credit line, it would just be smart business to have one.”
“When you don't need funding, that's when you should look for it,” Dias added. “Because when you do need it, most likely your company's in trouble. And for most traditional banks, it's a lot harder to get approved at that point.”
Dias and Wright said loans help to cover the “foundations of business” like hiring, payroll, equipment, website and marketing. Though where the majority of funds go depends on the type of company.
Types of Business Loans
Dias and Wright said the most common business loans are lines of credit, term loans and SBA loans.
Experian said a small business line of credit works like a credit card: You withdraw funds up to a predetermined limit, then repay them with interest. NerdWallet says lines of credit are best for short-term needs like inventory or payroll.
NerdWallet also said a small business term loan involves borrowing a lump sum of money the borrower must pay back on a fixed schedule. This is the better choice for long-term investments like renovations and equipment purchases.
Experian added that equipment loans are another option to help buy new or replace existing equipment. Industries like the medical field benefit from these loans.
U.S. Small Business Administration (SBA) loans can be a useful resource for long- and short-term needs. The federal government backs SBA loans.
“A bank provides SBA [loans] and if for some reason that company defaults on the loan, the government steps in and they'll pay a percentage back to the bank,” Dias said. “So a lot of people think for whatever reason the SBA means getting a loan directly from the government, but that’s not the case. It's still through a bank. It's just the government's guaranteeing it.”
“As long as they fit the criteria, [SBA] is an easier loan to obtain typically because the banks understand not all their money is being used,” Wright added. “They have a backing for it.”
Dias said SBA loans come in different forms. A collateralized SBA requires the client to be a strong candidate with collateral, or something to offer if they can’t repay the loan.
SBA Express loans don’t require collateral but tend to be smaller. Most banks don’t offer them, but lending companies like Dias’ Small Business Lending Source do. SBA Express requires companies to have a minimum of two years in business, so they are not a good fit for startups. However, they can be useful for smaller, established businesses.
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Finding the Right Lending Source
Dias recommends starting with your bank when searching for a loan. If the bank doesn’t approve you, go online to find other funding sources. According to Experian, the most common ones outside of commercial and community banks are direct online lenders, and peer-to-peer lending sites.
A direct online lender provides the money head-on. A peer-to-peer lending site will serve as a middleman between you and a group of investors. Each is faster to acquire than a bank loan, but can cost more and have higher interest rates.
Dias said to seek a lender who covers various funding types if you are looking online.
“You want to make sure they have an array of different products because some of these companies out there online are going to push somebody into a product that’s not in the best interest for the client… because they don’t offer all these different products,” Dias said.
Also, finding a lending company can help reduce some of the complications you might encounter when finding a loan yourself.
“You can walk into one bank, they can completely deny you, and it's not that the SBA denied you, it's the underwriter,” Dias said. “For whatever reason, they might not like working with that manufacturing or construction company. However, you can go right across the street and that underwriter likes working with them and then they could possibly approve you.
“So one thing when working with alternative lending spaces, if they have access to different loan products like SBA Express, bridge-type funding, credit lines, we know what certain underwriters are looking for. So we're not going to waste a lot of time by going to a bank that doesn't like to work with construction or whatever the case is.”
Applying for a Business Loan
Dias said startups applying for a loan must complete an application and an updated credit report. Revenue-generating businesses need an application and four months of business bank statements. Then the company or bank you are working with can determine what you qualify for.
Most startups require a credit score of at least 680 and tax returns that show you make at least $70,000 a year to qualify for a loan, according to Dias. The minimum annual income increases to about $100,000, and the credit score decreases to about 650 for revenue-generating businesses looking for loans.
If you can’t acquire funds for a business loan, Wright suggests purchase order financing. Under this system, a lender pays the manufacturer to fulfill a customer’s order. Once the customer receives their order, you invoice them and send the money to the lender, who then takes a portion of the money and gives you the rest.
Wright added that purchase orders can help obtain a loan.
“A lot of those purchase orders can be used as collateral to get funded, so it allows you to grow,” Wright said. “That's one of the best ways if you're selling to consumers or are a service business.”
Consider what kind of collateral you would be willing to risk should the loan require it. Wright said real estate is a good collateral source if you are already purchasing it for the company.
Wright also recommends building your credit score and funds if you’re searching for a loan based on personal credit. Aim for a score above 700 and “as much cash as possible in the bank.”
“You can be in business for a year and a half and you're still a startup,” Wright said. “That's because so many fail… So definitely have a lot of savings. If you don't have that [and a good credit score], you need someone that you can use as a credit partner.”
“While it’s not necessary, it's always good to at least have one or two business credit cards,” Dias added. “If you have all those ducks in line, at that point you can pretty much qualify for any type of business loan product that's out there on the market.”
Top Takeaways
What to Know About Business Loans