What is a Startup Micro Loan?
A startup microloan is a loan of $50,000 or less to a new business. There is no precise definition of a startup, but it is used mainly to denote a business which has yet to make most of its potential revenue, usually a business that has existed for less than two years. While the maximum value for a microloan is $50,000, few exceed $35,000, and the average microloan is around $13,000. Since microloans are so much smaller than traditional loans, they are considered lower risk. For many startups, which lack credit and revenue history, microloans are the safest, and sometimes only, option. Some microloans are associated with the Small Business Association (SBA) or to a nonprofit organization. These loans are often given at a lower rate to help stimulate growth and innovation or to help create a more equitable society.
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Rates for startup microloans tend to be higher than traditional loans for a few reasons. Startups are considered at high risk. The majority of startups fail within the five years, and when a startup asks for its first loan, there is relatively little data for a lender to judge if a particular business will be among the ones which succeed. Lenders charge higher rates as a way to compensate for the risk that the business will default. Another factor which raises the rates of microloans is the underwriting cost. Since the administrative cost for a lender is roughly the same for a large loan or a small loan, the cost in terms of a percentage is much higher. Lenders need to charge higher rates on microloans to pay for these costs. For the same reason, your rate will likely be higher for a $1000 microloan than it would for a $20,000 microloan. Typically businesses which offer collateral have lower rates than businesses which do. If a borrower provides something value which the lender can take in the circumstance that they default on their loans, then the loan will be considered lower risk by the lender. SBA backed microloans work on a similar principle. In some circumstances, the SBA will agree to guarantee repayment a certain percentage a loan if the borrower fails to make payments. This guarantee helps lower the rates because the risk of not receiving payment is much lower for the lender. Some nonprofits provide lower interest or even zero interest loans to businesses owned by people from socially or economically disadvantaged backgrounds. These loans have lower rates because the intention behind the loans is not to make a profit, but to help create a more equitable society.
Since microloans are so much smaller than traditional loans, the credit requirements tend to be more relaxed. As startups tend to have a little-to-no business credit history, lenders make their risk assessment on other factors. For most lenders personal credit plays a more significant role, many asking for an excellent score (720 or better). However, some lenders will accept a lower personal credit score if the borrower has a well-developed business plan, or if the business has some revenue history. Offering collateral also helps to reduce credit requirements. Lenders also recognize the value of self-investment. If you put a significant amount of your own money into your startup, lenders may be more lenient about their credit requirements. There are very small credit building microloans (from a few hundred to a couple of thousand dollars) that have lower credit requirements. These credit building loans are less about acquiring capital and more about establishing or improving your business credit. The SBA backs loans for businesses either to stimulate job growth in a community or to support owners from disadvantaged backgrounds. Most lenders will lower their credit requirements for businesses with SBA backing.
For Bad Credit
Startups are already considered high-risk ventures by most lenders, and having bad credit on top of it does not help. However, there are options for businesses with bad credit. Since your credit score will affect your rates even if you are approved for a loan, it is ideal if you can improve your credit score. The quickest and easiest way to improve your score is to check your credit history for errors. On occasion, a borrower will have bad credit due to a clerical error, such as a payment failing to be recorded. All three major credit checking firms will provide you with your credit history free of charge. If you can prove, there is an error it is possible to correct your history and improve your credit instantly. Even if there is no error, it is wise to review your credit history to gain a better understanding of how you ended up with bad credit. If you have the means to pay or consolidate your outstanding debt, that can improve your credit rating. There is also the option of getting a business credit card, or a very small, credit building microloan, to help establish good credit and gradually reverse your bad credit history. Several nonprofit lenders specialize in microloans for startups owned by people from a disadvantaged background. These lenders are more likely to look at bad credit in the context in which it occurred, overlooking past mistakes if they believe that you will not repeat them.
Government grants for startups are very appealing: acquiring funding without the need to pay it back. However, it is worth noting that grants are rarely given to businesses outside of high-tech industries. If your business is high-tech, you may qualify for the Small Business Innovation Research Program (SBIR). This grant is to help small businesses pay for research and development to compete with larger businesses. SBIRs are given most frequently to businesses developing technologies which have a direct application for the government, in fields like healthcare, public transport, or defense. To qualify for an SBIR, your business needs to be majority owned by a US citizen and needs to have fewer than 500 employees.
Secured vs. Unsecured
A secured microloan is a loan in which the borrower offers collateral. Collateral is something which has roughly equal value as the loan that the lender can seize if the borrower fails to repay. An unsecured loan, conversely, is a loan made without any collateral. Since collateral allows a lender to recoup their losses, secured loans are considered to be much lower-risk than unsecured loans. This lowered risk means the microloan will likely have lower rates and lower credit requirements. Since startups have no business-credit history, they are less likely to be approved for unsecured loans than more established businesses.
If you’re unsure whether a microloan is the right borrowing option for you, or you’re not sure how to go about getting one, talking to an expert is always a good way to make sure you’re on the right track for your finances. Starting a new business is big, and you’ll want to make sure you’ve got all the information you need to go about it the best way possible. Goodluck!