Rob, the small but busy construction business owner renovating my old townhouse, made an interesting observation about business loans one day over our morning brew. He said, “Lenders offer you money when you don’t need it, but not when you do need it, like during a pandemic!”
He has a point, and that’s a problem for many small business owners. Fortunately, small business loans are available if you know where to look. For example, you can get business loans to fund your new business, assist in daily operations, buy equipment, or cover cash-flow shortfalls. But you’ve got to be careful because not all lenders have your best interest at heart!
Together, we’ll navigate the minefield of scam or inefficient loans and look at secure small business loan options, such as grants, SBA microloans, and banks. We’ll also dive into interest rates, personal guarantees, unsecured loans, and business collateral, so you know how to get a small business loan that suits your business.
Start-up costs are a big barrier to cross when setting up a new business, so understanding how small business loans can (and can’t) help you is key. Read on to learn more.
Business loans are a popular way for many entrepreneurs to support their business needs. You can use them for many purposes, such as your business set-up, stock, equipment, hiring staff, or marketing.
Lenders provide business loans to business owners for exclusive use in their operations. Business owners then repay the loan over an agreed period plus interest.
But we all need a business loan for different reasons. Here are some of the most common:
Before we look at how to get a business loan, there are a few key terms you’ll need to know, so we’ll begin with those:
Lenders love business jargon, whether it’s the name of the loan or its terms and conditions. Some lenders use it to sound professional, others to deceive the borrower. But as Einstein once said, “Genius is making complex ideas simple, not making simple ideas complex.”
With Einstein in mind, let’s simplify the business jargon to ensure you understand these complicated-sounding terms, so you know what you’re signing.
Collateral loans work by a borrower agreeing to give a lender something to replace the loan if they can’t pay it back, such as business assets. Sure, these loans are risky, and you’ll need expendable business assets to get one, but they often have their perks (I’ll tell you more in just a minute).
An alternative option to collateral loans is no-collateral loans that don’t require you to take on personal financial responsibility, one of which is an unsecured loan.
Unsecured loans (also known as signature loans) don’t require collateral and only need your signature. Businesses that offer unsecured loans are credit unions, banks, and online lenders and include revolving credit like credit cards and student or personal loans.
Note: Many small new businesses fund themselves using a low-interest business credit card. I did when starting my first e-commerce business, and I still use that card today.
Personal guarantees are like collateral loans. The difference, however, is that you’re responsible for repayment, not your business. I’ll use myself as an example of how it works.
I own an LTD (the U.K. equivalent of an LLC) and took a traditional business loan to fund product expansion. The bank, however, only gave me the loan if I signed as a guarantor. The result is, even though I own an LTD with limited liability protection, I’m on the hook for the loan if it should fail.
You may be asking, “Why would you do that?” If so, great question. Stick with me and I’ll explain when we look at how interest rates work.
Peer-to-peer (P2P) is an online service that enables you to get a loan from another person, removing any financial institution’s intermediaries.
P2P lending provides small business owners an alternative if financial institutions refuse their loan application due to bad credit ratings; however, interest rates are higher than traditional loans.
Interest is how lenders (banks, credit unions, etc.) profit from giving you a loan. For example, you own a gym and need a $50,000 business loan for new equipment. Your local bank charges a fixed annual percentage rate (which doesn’t change) of 10% over a 10-year repayment plan.
You’ll repay $5,000 off the loan yearly plus $500 interest. By year 10, you’ll have paid back $55,000.
Interest rates come in two forms: fixed and variable. Fixed interest rates stay the same throughout a loan, whereas variable ones can go up or down. Variable rates are often lower than fixed, making them an attractive option; however, you risk paying a higher rate should they go up.
Financial institutions often offer interest rates based on your business credit score. A business with a higher score gets a lower rate because lenders see them as a safe bet. And interest rates are often lower if you take a collateral loan or act as a guarantor.
A business credit score measures your business’s creditworthiness; a personal credit score measures your creditworthiness. Financial institutions often judge new companies on the owner’s credit score until the business builds up its own.
Here’s how they both work:
Credit bureaus analyze your credit files and then score you using numerical values, similar to a thermometer or your car’s speedometer.
Business credit scores range from 0 to 100; the higher your score, the better your business credit rating. Personal credit scores have four stages, ranging from 300 to 850:
You get free credit reports from three major credit bureaus: Experian, Equifax, and TransUnion. Or use personal finance websites or credit card issuers.
The business loan world used to be pretty straightforward with traditional loans being the primary option. Lenders, like banks and credit unions, provide traditional loans, which is the most common type of debt financing for small to medium-sized businesses. Traditional business loans often offer the lowest interest rates and best conditions; however, you’ll need a strong credit rating to get one.
Fast forward to 2022, business loan lender options are everywhere, and many exist for specific purposes. For example, you can get a business loan to start your business, for equipment, and even purchase real estate. But before you choose your business loan provider, determine which type of financing suits your business needs and growth goals because all have their advantages.
And an excellent place to start is with a Small Business Administration (SBA) backed loan.
The U.S. SBA serves to help small businesses like yours get funding from eligible lenders that meet their strict requirements. SBA-approved loans suit start-ups and small to medium businesses that have yet to build a strong credit rating and require capital to grow.
Business term loans are traditional loans. You borrow money from a traditional lender, such as a bank or credit union, which gives you a lump sum of cash. You pay it back at set intervals over an agreed time plus interest.
Invoice financing (also known as purchasing accounts receivable) is a lending model where a financial institution provides a short-term business loan to the value of an outstanding invoice for a percentage fee.
As invoices can take up to 90 days to clear, many small businesses need invoice financing to cover shortfalls in cash flow that can harm their daily operations and growth strategies.
But of course, there’s a downside as small businesses that use invoice financing lose a percentage of their overall income.
Business lines of credit loans are another popular way small businesses can gain funding to cover day-to-day expenses.
Lines of credit work by providing flexible funding options that enable you to get financing to cover unforeseen expenses, such as unexpected repairs or global economic unrest.
As the name suggests, business micro-loans are smaller loans ranging from $5,000 to $50,000. A business that doesn’t meet the credit score requirements of a traditional lender can get micro-loans from different government bodies or by partnering with a non-profit agency. But as with all loans, micro-loans come with terms/conditions and interest.
Merchant cash advance lenders provide business loans for a percentage of your future credit card sales transactions.
Repayments are based on a daily percentage of your business’s credit card transactions and fluctuate depending on the number of transactions and how much those transactions are worth.
Knowing what lenders look for when providing a business loan can increase your chances of getting one. Sure, some online lenders have less stringent requirements than traditional lenders, but tread carefully because, as the saying goes, “If it sounds too good to be true, it probably is.” Allow me to explain why:
Online financing is convenient, but it increases the risk of falling prey to predatory business loans. Predatory business loans serve the lender—not the borrower—by tying small business owners into abusive and unmanageable loan terms.
You spot predatory business loans by their aggressive solicitations, encouragement to flip loans (taking on a new high-cost, long-term loan), excessive borrowing costs, and high prepayment penalties.
And you avoid them by ensuring lenders disclose their annual percentage rate and full repayment schedule. Also, survey all competing offers and consider speaking with an accountant or financial planner before signing a dotted line.
Not all U.S. states have predatory lending laws, but those that do include California, Colorado, Connecticut, Florida, Kentucky, Maine, Maryland, Nevada, Ohio, Oklahoma, Oregon, Pennsylvania, Texas, Utah, Wisconsin, and West Virginia.
You evaluate your business costs to ensure you don’t borrow more than you can afford and to determine how long you’ll need to repay it.
The best time to evaluate your business costs is when writing your business plan’s financial strategy. Because then you’ll know if you need a start-up loan, and to get one, you’ll need a business plan!
Your business plan’s financial strategy is also helpful if you don’t need a start-up loan, as it’s usable when planning to borrow for future expansion. Business costs include the cost of your daily operations, such as inventory, equipment, travel, property, insurance, staff, licenses, permits, utilities, and any current business debts.
With costs in hand, you can calculate what you can afford; we’ll look at how next:
You should always consider how you’ll pay it back when you borrow money. In business, that means evaluating your debits and credits (outgoings and income). Especially cash flow, as that’s what many small businesses use to repay their loans.
Here’s a formula for calculating business costs:
Fixed costs remain constant regardless of production output and can include rental payments, insurance, utilities, and wages. Variable costs change relative to the production amount and can comprise materials, fuel, extra labor, and commissions.
Now you can work out how much you can borrow:
The general guideline on income and expenditure is your total income should be a minimum of 1.25 times your total expenses, including any new business loan.
For example, let’s say your food truck business generates $20,000 in income per month, which is 1.25 times $16,000 in expenses, and your TFC + TVC is $14,000 per month. In this scenario, you should be able to afford $2,000 per month on loan repayments.
But only if your cash flow allows it because some lenders require weekly or daily repayments. So, consider the loan conditions and your cash flow to ensure you can make them when they’re due.
Not all loans are equal and deciding what type of loan you need before talking with lenders can help you get a better deal. Yes, low-interest rates and great T&Cs are essential. Still, the type of loan you might need also depends on factors like speed, availability, and repayment schedules.
For instance, some small businesses need quick loans; here’s where a line of credit or a merchant cash advance might suit. Invoice financing could solve any slow cash flow problems harming your daily operations. And if you’re expanding and have a good credit rating, a traditional loan could offer the lowest interest rates.
You can save time and hassle from loan refusals by first determining if you qualify for a business loan. For example, when applying for a traditional loan, you’ll require a strong business or personal credit score, one to three years of financial records (depending on the lender), or collateral to qualify.
Non-traditional lenders might require proof of your cash flow, business revenue, unused credit lines, outstanding debt, and an account of your investment in your business.
Financial institutions (traditional and non-traditional) use these variables to calculate the interest they’ll charge and your ability to repay the loan. And some lenders require a minimum annual revenue before offering loans or credit, ranging from $50,000 to $250,000.
Where your revenue isn’t high enough, you could consider an SBA micro-loan, a credit card, or a collateral loan.
If you default on a loan, collateralizing means you agree to allow the lender to take something your business owns in place of the repayments, like your truck or computer hardware.
Yes, it’s risky, but sometimes it’s necessary to increase the amount you can borrow and get lower interest rates. You should only collateralize a loan after you’ve done your due diligence and validated the reason for taking it.
Jean Chatzky, the founder and CEO of multimedia company HerMoney, gives this advice about loans: “Just because someone will lend you money doesn’t mean you should borrow it.”
It means you should always run a comparison check using the same variables with as many other business loan lenders as possible before you sign to ensure you get the best deal. When comparing business loans, consider the business lender’s processing time, customer service, flexible repayment schedules, and reputation.
Congratulations, you made it! Now all you have to do is evaluate your options and choose the right business loan for you.
Remember, look at several similar options and compare their annual percentage rate and loan terms, also known as APR. APR includes the interest rates and loan fees, so it’s the best way to ensure you understand the total cost of your business loan.
And suppose your credit score is below a lender’s threshold or your business doesn’t have one. In that case, you can consider non-traditional lenders, like invoice financing or micro-loans.
Getting a small business loan can be challenging, especially if you don’t have a strong credit rating, need to provide collateral, or act as a personal guarantee.
If that’s you, the Small Business Administration (SBA) is an excellent resource for small business owners as it provides non-collateral financing opportunities, so check them out.
Besides the SBA, many non-collateral business lenders are available but read the terms and conditions as the interest rates are often higher.
My last advice on loans is: When considering a business loan, choose the conditions that work best for your business, don’t borrow more than you can realistically repay, and never risk collateral you can’t afford to lose.
I’ll leave the final word to Oscar Wilde, “Always borrow money from a pessimist; they won’t expect it back.” If only!
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