Small Business Lending 101: What Every Entrepreneur Should Know

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Updated on Monday, January 21, 2019

Small business lending 101

Before you sit down at a bank — or in front of a keyboard — to apply for a business loan, there are a few questions you should ask yourself. How much money do you want to borrow? What is the loan for and why do you need it? Those might seem like obvious questions, but many business owners don’t have the answers when they apply for loans.

Navigating the loan process can be tough. Asking for as much money as you can get might put you on the hook for way more than you can afford to pay back. Asking for too little could cause problems if you underestimated your costs.

You must first figure out what you need to use the money for — business expansion, equipment purchase, debt payoff, inventory — and then determine how much you can realistically afford to repay, making sure you include all fees and interest. If you’re looking at a term loan, for example, you can use an online amortization schedule calculator to estimate your monthly loan payments.

Ideally, the only time a business owner should take out a business loan is to increase sales or increase profit margins, according to the Women’s Business Development Center in Chicago. That might not always be practical, but you should always proceed with caution when you need money quickly to cover immediate business expenses; that’s when you’re most likely to pay high interest rates and fees.

What’s your business profile?

There are three main factors that traditional lenders look at when they consider your business loan application:

  1. Your personal credit score
  2. Time in business
  3. Annual business revenue.

Personal credit score

Most lenders give more weight to your personal credit than your business credit score because they consider that a more accurate sign of how consistently you pay down debts. Most banks and credit unions want to see a score of at least 680, but possibly as high as 720. The higher your score, the better your chances of being approved — and getting a good interest rate.

Time in business

Traditional lenders often require two years in business and will request proof by looking at two years’ worth of business statements. That can make it tough for new businesses to get a loan from a traditional lender, but you’ll stand a better shot if you have good credit, strong business sales and collateral.

Annual revenue

Most traditional lenders want to lend to a business that’s bringing in at least $100,000 a year in revenue. The lender wants to be confident you have enough money coming in — and not too much going out — so you can successfully manage your new loan payment.

Types of lenders

To get approved for a loan from a bank, credit union or government partners like the U.S. Small Business Administration, the requirements are similar. And online lenders’ requirements are typically less stringent. As a rule of thumb, keep in mind that the faster and easier it is to get a loan, the more expensive it will be. Read on to find out more about different financial institutions’ requirements:

  • Banks. Most people think about traditional banks when considering a loan. Although big banks are household names — Chase, Bank of America, Citigroup, Wells Fargo — they approve only 25% of small business loans. Smaller institutions, sometimes called community banks, are often defined as those with $10 billion or less in assets. According to the Biz2Credit Small Business Lending Index, small banks approved 49.1% of small business loans in January 2018. Whether large or small, banks’ loan requirements are stricter than online lenders, but they generally offer the best interest rates.
  • Credit unions. Credit unions are nonprofit institutions that usually require membership to get a loan. Although they have roughly the same loan requirements as traditional banks, they offer additional benefits because they’re nonprofits. Credit unions often give profits back to their members in the form of lower loan rates, higher savings or checking account rates and reduced fees. Credit unions’ small business loan approval rate was 40.3% in January 2018.
  • Government partner institutions/organizations. The U.S. Small Business Administration is the largest provider of government-backed loans. The SBA doesn’t directly lend money to business owners. Instead, it guarantees a portion of the loan that a lender approves. SBA lenders are typically banks and credit unions, although a few alternative lenders offer SBA loans. SBA business loans are tough to get — you need approval from the SBA and the lender — but they have low interest rates, long terms and high borrowing limits.The U.S. Department of Agriculture offers similar loan terms to borrowers, but approves loans only for rural projects. To get approved, your project must be located in an area with fewer than 50,000 people.
  • Online lenders. Sometimes called alternative lenders, these are online-based lenders who specialize in approving loans very quickly — potentially just a day or two — and offer less-stringent approval requirements. These lenders typically require a credit score between 620 and 640 (in the fair range), $50,000 in annual revenue and six months to a year in business. They almost always, however, charge much higher interest rates. A traditional bank loan might have an interest rate range of 5% to 10%, but an online lender can likely charge 7% to 30%. Online lenders approved 56.6% of small business loans in January of 2018.

Types of small business lending

It’s important to consider two things when getting a loan: the type you need and where you get it. A good rule of thumb is to use short-term debt to finance short-term expenses (like equipment that you’ll need to replace in less than a year) and long-term debt for long-term expenses (like equipment that you’ll need to replace in 12 to 48 months).

Review these seven types of small business lending products:

Personal loans

Personal loan approvals depend on your personal credit score. A personal loan might be a good option if you haven’t been in business very long — it can be tough for newer businesses to get a business loan.

You can secure a personal loan with collateral, such as a car title or a mortgage, or get an unsecured loan. Loan approval can be quick — anywhere from a day to a week — and you won’t have to fill out as much paperwork as you would with a traditional business loan. Keep in mind, however, that if your business fails and you default on the loan, your personal credit will take a big hit and your personal assets could be at risk.

Term loans

Traditional bank term loans are pretty straightforward — you borrow a set amount at a fixed interest rate and repay it over a period of time. These loans have some of the lowest interest rates, but you’ll need to have been in business for at least two years, have good credit and put up collateral. The term loan approval process can be lengthy.

Lines of credit

A line of credit allows business owners to draw from a set amount of credit and pay interest only on the amount they borrow. Once you repay the amount you borrowed, it becomes available to you again. These loans are good for seasonal businesses or those that need money to cover a cash flow gap. Most business lines of credit don’t require collateral.

Government-backed loans

Small business loans like those from the U.S. Small Business Administration or the U.S. Department of Agriculture are great options for stable businesses. They offer reasonable interest rates and long terms — and lenders might be more willing to loan to riskier borrowers because the government guarantees a portion of the loan. That doesn’t mean you’re off the hook if you default, though. You typically sign a personal guarantee that you will repay the loan, and that guarantee means lenders can try to collect their losses through your personal assets. The application process can also be lengthy, so this isn’t a good option if you need a quick cash injection for your business.

Specialty financing

Specialty financing includes loans for very specific purchases, such as leasing or buying equipment. You usually pay equipment loans over the estimated lifespan of the equipment you’re financing, and the equipment serves as collateral. Specialty financing also includes commercial real estate loans, which are designed for buying income-producing property for business use. The main drawback of these types of loans is that sometimes the length of the loan can be longer than the lifespan of the equipment.

Invoice financing

Invoice financing works like this: You use unpaid invoices as collateral to secure a cash advance, which is usually equal to a percentage of the invoice, but not the entire amount. You repay the advance along with a monthly fee, which ranges from 2% to 4% of the invoice value.

Invoice factoring, a similar alternative, works like this: You sell your outstanding invoices to a factoring company. The factoring company then collects on the outstanding invoices and gives you the full value of the invoices —minus a factoring fee, which is usually 3% to 5% of the value of the invoices.

Cash advances

When you take out a merchant cash advance, you get a lump sum of money that you pay back through a percentage of your credit sales each day. Your interest rate is based on a factor rate, which depends on your personal application. Cash advance merchants are more interested in the amount of sales your company makes than your credit score.

Cash advances are quick and fairly easy to get, but they can be very expensive because you must pay them quickly. These types of advances can come with an APR as high as 200%. You might also be able to take out a cash advance from a business credit card, but that’s another expensive option. Think of MCAs as a last alternative when it comes to business loans.

Finding the right loan for your business

Before you apply for a loan, make sure you fully understand the process and are aware of all your borrowing options. Research different types of loans and their approval requirements so you have a good idea of what will work best for your business. Here are some key things to consider before you apply:

  • Eligibility requirements. If it’s highly unlikely that you’ll get approved for a traditional bank loan, it might not be worth it to apply for one because the financial institution will conduct a hard pull on your credit. At the minimum, the three things you should know are your credit score, annual revenue and time in business. If you have poor credit and are running a newer business, you’ll probably want to start your search with online lenders. You might, however, be able to balance out any weaknesses in your application by providing collateral.
  • Time to funding. A traditional lender is a good fit for you if you meet all the requirements and you can wait as long as two months to get funding. If you need funding right away, however, it’s best to consider online lenders who can sometimes approve a loan within 24 hours.
  • Total cost. Make sure you know how much the total loan will cost over its term. In addition to the interest rate, many loans come with origination fees (lenders charge this to process a loan), a maintenance fee (lenders typically charge this annually) and a draw fee for borrowing from a line of credit. Evaluate the pros and cons of the timing of your funds vs. the total cost you’ll pay for those funds. If you choose a merchant cash advance, for example, make sure you know how the factor rate will be converted into an APR.

Getting approved: documents you’ll need

If you get a loan from a traditional bank or credit union, you’ll need to provide a lot of documentation and sign a lot of paperwork. Keep in mind that online lenders usually require less documentation. Here are some of the common documents you’ll need:

  1. Business financial statements. These will include a current profit and loss statement from the last three fiscal years, a cash flow statement and your balance sheet, both of which should be from the last 60 to 90 days.
  2. Bank statements. Some lenders require the last three months of your business bank statements to verify that you have a business banking account and enough cash to make loan payments.
  3. Current loan documents or leases. If you currently have a small business loan or equipment lease, you’ll need to disclose those documents. You’ll probably also have to provide a business lease or mortgage if you own the property where you run your business.
  4. Income tax returns. You’ll need the last three years of signed personal and business income tax returns. Online lenders might not require this for new businesses.
  5. Ownership and affiliations. Be ready to disclose any other businesses in which you have a financial interest. If you have partners, they might need to sign some of the paperwork, too.
  6. A business plan. Although many lenders don’t require a detailed business plan, most traditional bank loan lenders do. The SBA requires you to submit an in-depth business to get approved for a loan. You can find tips for writing a business plan, here.

The bottom line

Doing your research before you apply for a loan can save you a lot of money and trouble in the long run. Make sure you know exactly how much a loan will cost — and that you can afford the payments. Also make sure you understand exactly what will happen if you miss a payment or default on the loan. Most important, before you take out a loan, make sure that the funding will help you accomplish something positive for your business and not just add more debt.

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