The Definitive Guide to Business Lending

Every loan. Broken down. In one place. The OL Definitive Guide to Small Business Lending is the last article you'll ever need to read about how to best finance your small business. You're welcome.
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The Definitive Guide to Small Business Lending

When it comes to running a business, you’ll run into lots of different expenses, like real estate, equipment, inventory, or payroll. Sometimes these costs can be predictable, but often the amount you’ll need from a loan is something you can only really know once you’re business gets running. Unless you’re able to finance every aspect of your business with your own money, chances are you’ll need to look into financing some part of your operation with a loan.

Luckily, there are a lot of different borrowing options for business owners, depending on how much you need, what you need it for, and what kind of shape your credit is in. We’ll first look into some common types of business loans, then go over how you can go about getting approved for one.

Types of Business Loans

Here are some descriptions of popular business loans that cover a wide range of uses, from general financing, to fixed assets, to startups.

SBA 7a Loans

The Small Business Administration (SBA) has different loan programs for helping small or new businesses grow. They way they work is the SBA makes an agreement with your lender to back your loan, meaning they’ll pay back the lender if it happens that you can’t afford your payments. This guarantee gives lenders extra incentive to approve loans for business owners, since they’re at less of a risk of losing money. The result is that SBA loans tend to have pretty good terms, like low interest rates and low credit requirements.  

The SBA 7a loan is the SBA’s most popular loan program. It can be used for any business costs, from equipment or real estate, to working capital, refinancing business-debt, or even buying an existing business. They can be for amounts of up to $5 million, and have an average yearly interest rate of 6.3-10%. Average down payments are between 10-20%, and payment terms can be 7, 10, or 25 years long.

SBA 7a loans also have an express option, where the maximum amount is much smaller (up to $350k), but it will only take 2 weeks or so to get your funding. This is much quicker than regular SBA 7a loans that usually take 2-3 months to process. SBA 7a Express loans are also smaller, meaning lenders are at less of a risk and more likely to approve your application. Quick funding and easier approval makes these a good option for if you’re the owner for a new business, or if you’re looking to start a new business, since you’ll have little or no business credit history.

SBA 504 Loans

SBA 504 loans (also known as SBA CDC loans) are for specific business costs known as fixed assets, which includes anything from equipment, to real estate, construction, or repairs and renovations. SBA 504 are usually 40% provided by a Certified Development Company (CDC), and 50% by a bank, meaning you’ll only need to put up 10% of the loan yourself. They also have very low interest rates (4-5%), and payment terms are usually 25 years, making them an overall attractive option for business owners.

Microloans

If your business hasn’t been running long (less than 2-3 years), you won’t have much of a business credit history, and this can make it hard to get approved for a large business loan. This is where microloans can come in handy. Microloans are small loans, usually between $1,000-$35,000, which makes them less risky for lenders to give out, and easier for business owners to get approval for.  

The downside to microloans is that they’ll usually have higher interest rates than other loans. Still, their easy approvals makes them useful if you’re a new business owner, since by taking one out and paying it back you can build up your business credit. The SBA also offers microloan programs (as well as programs for the rest of the business loans listed below). Although they’re a little harder to get approval since the SBA has a fairly thorough credit check process, if you can get approved for one, the extra security for the lender will allow for lower interest rates than for a regular microloan.

Business Lines of Credit

A line of credit is like a loan where you take out portions as you need them, instead of being given the whole amount all at once. They basically work like a credit card, in that they’re “revolving,” meaning you only pay interest on the amount you withdraw, and if you pay that amount back before the loan period is up, your limit goes back to what it was before the withdrawal. This kind of setup is perfect for if your business is seasonal, generating more profit at certain times than others. It’s also handy for if your business expenses are unpredictable.

Interest rates on a line of credit can be anywhere between 5-20%, depending on your business credit history. If your business is new and doesn’t have much credit history, lenders will usually look at your personal credit history.

Your credit history will also help to determine how much collateral you’ll need to provide to secure the loan (unsecured business lines of credit do exist, but they’re rare). Most lenders will accept inventory, real estate, equipment, or business bank accounts as collateral. They may even ask for more than one of these, and in some cases (like if your credit is bad, or if the amount you’re requesting is very large) they may even ask that you provide all of your business assets as collateral.

Merchant Cash Advances

A merchant cash advance (MCA) is another way to get money for your business. They’re often used by business owners who don’t have enough credit history (or a good enough personal credit) to qualify for a regular loan. They’re also good for if you don’t have the time to wait for all the processing that loans take, since the funding time is much quicker.

A merchant cash advance works differently from business loans. In fact, it’s not technically a loan, since you’re actually selling a portion of your future sales in exchange for a lump sum. The sales portion is then collected over time as a percentage of your profits (usually between 20-40%) until the lender has received the amount you sold them. So if you sold $60,000 of your future sales for an advance of $50,000, a percentage of your sales each month will go to your lender until they’ve gotten back the whole $50,000.  

This flexibility can be a big advantage if used wisely. However, interest rates can be quite high on MCA’s, since they’re not technically loans, and so are not regulated by government-set interest limits. You’ll have to be very careful when finding an MCA provider, since this freedom has amounted to a trend of predatory lending.

Rates (%)

When considering the kind of loan you’ll want to take out for your business, one of the major things to take into account is how much you’ll pay in interest. Lenders might quote interest rates as a weekly, monthly, or yearly percentage of your loan amount. The most common way to talk about interest, and the best way to understand how much you’ll end up paying, is in terms of a yearly percentage, known as an APR (annual percentage rate). An annual rate can be converted into a monthly rate simply by dividing your APR by 12. So an APR of 10%, for example, would amount to a monthly interest rate of 0.8%, meaning you’d pay 0.8% of your total loan amount each month in interest.

An important thing to note about interest rates is that a high rate does not necessarily mean a large payment. That is, the amount you’ll end up paying in interest really depends on the size of the loan. On a microloan, for example, you might have a 20% APR, but if your loan is $10,000, your payments might still be easily affordable. Also, since microloans (and smaller loans generally) have short payment periods, you could take one out and pay it off quickly just to build your business credit history and become eligible for a larger loan with a much smaller rate. Ultimately, the real value of an interest rate will really depend on the size of your loan and how you use it.

Here are some average APRs for the loans discussed above:

  • SBA 7a loans: 6.3-10%
  • SBA 504 Loans: 4.64-5.31%
  • Microloans: 8-50%
  • Line of Credit: 8-80%
  • Merchant Cash Advance: 20-40%

Credit Requirements

The kind of business loan that’s best for you will depend not only on how much you need, but what you have to offer the lender for security. It’s how these factors balance together that will affect the terms of your loan, like how high your interest will be, and how long you’ll have to repay the loan. This makes both your business credit and your personal credit very important when applying for a business loan, since it’s the main thing a lender will use to get an idea of how much they’re at risk by lending to you.

If your business credit is good, and you have a high personal credit score (680-700), and a good financial background (no outstanding debts, no recent foreclosures or bankruptcy, etc.), then lenders will feel confident that you can afford to pay back your loan on time, which will lead to better terms for you.

If you’re business is new (less than 2-3 years), however, meeting these standards can be hard, since it takes time to build business credit. Luckily, there are a lot of different options for these kinds of situations. For one, using your business credit card often and always making your payments on time is a sure way to build up your business credit. Taking out a small loan is another good way to get your credit up, since small loans are easier to get approved for and can be paid off fairly quick.

This is where your personal credit comes into play, since this is where lenders will look if you don’t have a business credit history for them to consider. Like with business credit, you can build or improve your personal credit simply by making personal debts and paying them off on time. It’s important before you start looking for a lender to check both your personal and your business credit so that you can see whether they need to be improved.

Secured vs Unsecured Loans

Securing a loan is common way to help a lender feel safe even if your credit situation isn’t great. Providing collateral means agreeing to allow a lender to take something valuable if you find yourself unable to pay back your loan. You can use personal assets as collateral, like your home or vehicle, or business-related assets, like real estate or equipment. When you secure a loan with collateral, it’s another way to lower the lender’s risk of losing money by approving your loan. The difference is that with secured loans, it’s you who’s at risk, since something valuable of yours is on the line.

Many business loans are automatically secured, like equipment loans, where it’s the equipment itself that acts as collateral. Construction or real estate loans work the same way, where the lender has a right to sell the property and keep the profits if you can’t afford your payments on time.

The kinds of loans that aren’t necessarily secured are those that provide funds for general business needs, rather than a specific purpose, like real estate or equipment. For this kind of loan, you’ll need to provide collateral only if the lender decides they want extra security. This might be the case if you’ve got bad credit, as mentioned earlier, or if your business is only 2-3 years old.

Alternatives to Collateral

It might be that the extra collateral you would need to provide your lender is not something you’re willing to risk losing. In this case, there are other options for giving the lender the security they need to approve your loan request. While most business loans require some amount of collateral (like the equipment or property you’re purchasing with the loan), there are ways around having to provide extra assets to secure your loan.

One of the main ways to lower the risk for the lender is by requesting a smaller amount. Not only are smaller loans easier to get approved for, but using one (as long as you pay it off on time) will build your credit history, which might prepare you for taking out the larger loan you really need without having to put up extra collateral.

Another way to lower the amount you’re borrowing is by providing a larger down payment. For example, say a lender asks for a minimum down payment of 10% and requires you to put up some or all of your business assets as collateral. Depending on the lender, you may be able to get around the collateral by paying off more of the loan up front.

In other words, you'll be more likely to get your loan request approved by lowering your loan-to-value ratio (LTV). Your LTV is often what a lender will refer to when explaining how much they’re willing to lend you. It refers to the percentage they’re willing to provide of the funding you need, and the percentage is based on the value of what it is you’re purchasing. For example, if you need a loan for $500k worth of equipment, your lender might agree to provide an 80% LTV, meaning they’d be willing to lend you $400k. This would be the same as saying they require a 20% down payment.

Building up your business credit with smaller loans may take time, but it can earn you the credibility you need to be able to borrow larger amounts. This would be a safer way to get the funding you need, since you wouldn’t need to risk huge portions of your business, if not the whole of it.

How to Get a Business Loan

The first step to applying for a business loan is to gather all the financial documents your lender will want to look over. You'll want to make sure you ask your lender beforehand exactly what documents they’ll need, since having them all ready and submitting everything at once can make the processing time a lot shorter.

Exactly what documents you’ll need will vary depending on where you’re going for your loan. For example, bank lenders (especially if backed by the SBA) will usually require more documents than other private lenders or online lenders.

Here’s a list of basic documents you’re likely to need for most lenders:

  • Executive summary (explained in the next section)
  • P&L (Profit and loss) statements for the last 2 years
  • Tax returns for the last 2-3 years
  • Bank statements from for the last 3-12 months
  • Cash flow statements
  • Balance Sheets
  • Personal and business credit reports
  • Projections of future plans for developing your business  
  • Business licenses
  • Leases for equipment or commercial property
  • Resume (especially detailing any business or managerial experience)
  • Any third party contracts you may have, such as with suppliers or clients.
  • Proof of ownership of collateral
  • Description of how you’ll use the loan
  • Loan application

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Credit Reports

Your personal credit report can be requested for free from any of the main agencies, such as Equifax, TransUnion, and Experian. It’s important to look over the report yourself before submitting it to a lender, since they can often be outdated and have mistakes that will misrepresent your financial situation. The same goes for your business credit report. The only difference is that there will be a fee, anywhere between $40-$100. You can check your business credit with Experian, D&B, or FICO SBSS.

For SBA Loans

If you’re applying for an SBA loan, you’ll need to provide additional documents and fill out specific SBA forms. Some of the basic forms and documents you’ll need are:

  • SBA Form 4 - The application for your business loan
  • SBA Form 4i - An application for guaranty or participation to be filled out by your lender
  • SBA Form 912 - A statement of personal history.
  • A description of your business’ ownership structure, including any other business interests, like stock ownership or franchise.
  • Business Certificate (DBA)

Building Plan (for Construction Loans)

If you’re looking to get a construction loan, you’ll also need to include a building plan. Your business plan should outline all the different stages of the building process, with an estimate of the cost and time frame for the entire project.

An important part of your business plan will be a signed contract with a qualified builder. You’ll also need references for your builder, since your lender will want to be sure that your builder knows what they’re doing and that they have a good reputation.

For Startups

If you’re applying for a loan to start or develop your new business, this will change the kind of documents you’ll have access to, and you’ll need to go about the application process a little differently. Since you won’t have the 2-3 years of business experience that lenders usually require, you’ll need to emphasize other ways of assuring them that their money will be well invested. One way to do this is by making sure your personal credit is in good shape.

Checking your personal credit score is something you’ll need to do for just about any business loan, but if your business is new then the outcome will have a lot more influence on whether the lender accepts your application. This means it will be even more important not only to make sure that there are no mistakes on the report, but that your score is good as well. While 680 is considered a pretty good credit score, 700 or higher is more likely to ensure a lender that it will be safe to approve your loan.

Another important aspect of applying for startup loans is that your business plan will be even more important. Starting a new business is a risk, and lenders will need to be assured that you know what you’re doing. You’ll need to show that you’ve researched your market and understand how to distinguish yourself from other businesses within it. This will help your lender feel that they’re making a worthy investment by approving your loan.

Benefits of a Business Loan

It can take time to find the funding you need for your business. In some cases you may have to try one lender after another before you find one who accepts your application. Once you find one, however, it can be all you need to get your business running just how you want it. In general, applying for loans is a healthy exercise for business owners. Having all your financial and business documents in front of you can give you a good perspective on how your business is running. You might find you understand the way it works a lot better after going through the process of trying to find a lender.

Searching for business financing is also the kind of thing that will get a lot easier the more you go through it. While it can seem daunting in the beginning, sticking with it will help you develop a skill that can help you in any of your future business projects.