Taking out a business loan is more common than you might think. In the United States, about 16 percent of businesses are funded by banks. In comparison, 78 percent of business owners have said to use personal funds to launch their business, according to the U.S. Chamber of Commerce.
Accessing additional capital or funding can be one of the most important financial decisions any business owner or entrepreneur can make throughout their career. Whether it’s to expand current service offerings, launch a new product, or simply need assistance with day-to-day finances - a business loan can be that one winning ingredient for your business.
Unfortunately, the small business loan process can often be an obstacle that can stand between you and your business's success. Statistics show that around 52 percent of small businesses have not had their financial needs met due to not receiving any financing after applying, only receiving a portion of their requested funding, being debt averse, or simply feeling discouraged about the loan process.
Knowing through which channels to work, and understanding how the process works, you can find more effective ways to navigate the small business loan application process, allowing you the opportunity to get your business off the ground or start planning possible expansions.
Choose a business loan type.
By now you should mostly be informed about the different business loan types that are available. Each business loan is unique and can be used for a variety of financial needs.
Traditional Term Business Loans
For any entrepreneur looking to launch their business, whether that being a startup or scaling current operations, a traditional business loan can assist in funding larger, and potentially more expensive business-related projects.
As a business owner, you may be eligible to apply for a traditional business loan from a bank or the Small Business Administration (SBA). These loans are typically more common, seeing as an owner can repay the loan over a period of a fixed amount of time with interest.
The typical size of the loan will largely depend on various financial factors such as the number of years the business has been operating, annual revenue, and credit history.
Business Line of Credit
Another possible financial option might be a business line of credit which can help business owners fund smaller activities such as employee payroll, repaying suppliers, or looking to quickly access capital funding.
With a business line of credit, you have more flexibility to cover ordinary day-to-day business expenses, curbing the potential of missing payments or allowing accounts to go into arrears. This type of capital structure is commonly used for businesses that experience seasonal fluctuations, whereby they may have larger capital requirements during off-peak periods.
Similarly, you are able to apply for a business line of credit from your bank or an alternative lender. Be advised that with this type of capital funding, you may be subject to high interest rates, which can be anywhere between 8 percent and 60 percent. The amount of interest will largely depend on an individual's creditworthiness.
Decide on a lender
Next, you need to decide on the lender. While a bank may offer you better loan terms, you might be stuck paying exorbitant interest rates. On the other hand, the SBA is a safer option, but the application process can be tedious.
Traditional Banks
Banks can offer a variety of financial options and often have different loan products that have been specifically tailored to business owners. For instance, a bank may offer a small fixed-term loan for a new business applicant who’s seeking a loan amount of $10,000. The conditions of the loan agreement can then be tailored to fit the businesses’ financial needs and available capital structure.
One of the drawbacks of a bank loan may be the higher interest rate most loans are subject to. Current business loan interest rates are set between 6.14% and 12.47% but can change over time. Additionally, taking out a variable-rate loan might mean that interest rate repayments can increase should interest rates go up.
Small Business Administration
The SBA is considered to be one of the largest government-sponsored loan programs. They can provide more favorable loan terms, and some borrowers may be eligible to borrow up to $5 million however this mostly depends on business-related activities such as revenue, source of personal income, and years in operation.
Something to keep in mind with SBA loans is that borrowers typically need to make a down payment first before they are approved. On top of this, business owners may be subject to personal liability, should the business fail and they default on the loan. There are other considerations such as that the loan application process can take very long and there are limited loan option plans available for startup companies.
Online and Microlenders
Business owners can apply for a loan through an online lender or microlenders. These lenders typically approve loan applications quicker, compared to traditional banks, which can make the process easier. Seeing as these types of lenders have different underwriting standards, business owners may have more flexibility in terms of loan period repayment plans.
Seeing as these lenders are typically smaller compared to bigger financial service providers they might charge higher fees and interest rates on their loans. This could leave business owners with a higher debt-to-income ratio, and could increase their risk of personal liability should they default on the loan.
Credit Unions
With a credit union, you might find a mix of all other types of lending activities bundled together. For instance, credit unions are usually larger and have a more robust capital structure, which allows them to provide bigger loans to businesses at more favorable terms.
Similar to banks, a credit union might have more personalized loan products, while providing a more tailored and transparent approach to the process. Additionally, credit unions don’t often charge intangible tax on commercial mortgage loans, which could be beneficial for small businesses looking to expand into bigger spaces.
However, unlike banks, there may be several discrepancies a business owner may face such as having to work with a less-experienced or less-established credit union. More than this, some credit unions might not have multiple locations available, which could make it difficult for business owners in rural areas to access the necessary support.
Loan Affordability
Before starting the loan application process, you might want to consider how big of a loan you can take out based on a few factors, these may include:
Loan down payment
Some lenders might require you to make a down payment upfront. This is used as a way to secure your loan, but provides the bank with additional financial collateral should you fail to repay the loan or default on your debt. Lenders might use this as a way to calculate your level of risk and whether you have the necessary financial resources to cover the debt.
Down payments can vary depending on the lender. For example, a bank might require you to make a down payment of between 10 and 30 percent, while an SBA loan down payment can be up to 20 percent of the total loan amount. The larger of a down payment you can provide upfront, the lower your monthly installment payment will likely be.
Business debt
If your small business has a high debt-to-income ratio you might find it harder to obtain approval for a loan. This could be that a lender sees you as a higher risk with the potential of defaulting on your loan terms.
It’s best that any business owner considers their current debt, and makes necessary arrangements to lower their debt-to-income ratio. The more a business repays its debts, the more likely they are to receive a higher loan amount approval.
Credit score
Having a strong credit score will help you in the long term of being approved for a business loan, although this alone shouldn’t be used to support your application. Building a good credit score can take several years, and it’s best to start small before taking on bigger debt burdens.
Before you start shopping around, take a look at your current credit score. Typically a personal credit score of between 700 and 750 will help secure a business loan, while anything above 800 is considered a highly favorable credit score.
Available liquid assets
Sometimes having liquid assets, either a property, company vehicle, or any other form of large liquidity can help secure a business loan. You may be in the position to put up your liquid assets as collateral as a way to secure or back your loan.
In some cases, you might be fortunate to secure a larger loan should you provide a lender with bigger collateral. Keep in mind that this may increase your risk of losing most or partial ownership of your assets should you default on your loan or not be able to make payments.
Calculating the loan affordability is one of the most important steps throughout the process. Knowing your business’s financial leverage will allow you to properly plan ahead, and ensure that you have enough financial capital each month to cover loan repayments and still have enough money available to save or reinvest in your business.
You can also talk to a loan officer at your bank, credit union, or a financial advisor who specializes in business loan applications and affordability calculations.
Put a business plan together.
Something plenty of business owners don’t have ready when they are planning to apply for a business loan is a well-detailed business plan. Having a business plan is only a part of the process, and many lenders often require you to submit a business plan as a way to evaluate your business, the industry, and any other potential risks.
By investing the time to develop a business plan, you can carefully research your market and conduct a market analysis. Investigate your competitors and any other potential long-term competitors that may influence your business success. Help segment your target audience more appropriately, and help establish your business’s unique value proposition.
Many lenders can use these and other things such as your operational plan, any potential challenges, and long-term opportunities to determine your business’s level of risk and success.
There are some instances where a lender might not directly request a business plan, although these are far less frequent and as a business owner it’s important to know what your business is capable of doing, how you will mitigate risks, overcome obstacles and what are the near-term possibilities for future business expansion.
Secure vs Unsecured
You may have the option to choose between whether you want a secured or unsecured business loan. When considering all of your options, make sure to consider which of these will work best for you and your business.
Secured loan
Depending on the lender you decide to work with, you may have the option to provide an asset as a form of collateral. These are usually big-ticket items such as a property or inventory. You can use the collateral as a form of security for your loan.
There are some drawbacks, however:
- Secured loans can be harder to come by if you have fewer available assets.
- Should you fail to repay the loan the lender can sell your asset to cover the outstanding amount.
- The underwriting and approval process of secured loans might be longer compared to unsecured loans.
- You may be subject to a value assessment and will be required to submit the necessary documentation to prove ownership of the asset.
Unsecured loans
In a similar vein, an unsecured loan can provide you with much more flexibility seeing as you are not required to provide any form of collateral to secure the loan. This is particularly favorable among business owners looking to gain quick access to capital or who are experiencing rapid growth.
- Some of the drawbacks with unsecured loans include:
- You may be subject to a higher interest rate.
- Unsecured loans can have longer and more complicated approval requirements.
- An unsecured loan can increase the businesses’ debt-to-income ratio.
- Having an unsecured loan can take very long to repay.
Not all lenders may provide the option of secured or unsecured loans, however, the best option will usually depend on several financial factors which need to be carefully examined. It’s advised to consult with an underwriter, loan officer, or financial advisor for more guidance on which option is best suitable for your business and long-term outlook.
Frequently Asked Questions
What can I use as collateral for a business loan?
Several financial instruments may be used as a form of collateral for securing a business loan. Some of these might include real estate, business equipment and inventory, cash, invoices receivable, blanket lien, and investment collateral such as stocks, bonds, and Certificates of Deposits. Be sure to revise all of your options, seeing as the value of each asset may decline over time, such as the case where CD rates over time may decline with lower interest rates.
When is a good time to take out a business loan?
Each business owner might experience various financial requirements throughout their business cycle. Some entrepreneurs take out business loans early on to help them start, although this might be more risky, seeing as the business might fail. Other owners might take out a loan to help with business expansions or use the capital for day-to-day costs. The answer will likely depend on where in the business cycle you currently are.
How big of a business loan can I take out?
Each lender may provide different types of loan products which may influence the minimum or maximum a business owner can lend at any given time. In some instances, the Small Business Administration may provide business loans between $50,000 to $5 million. Other lenders such as banks may offer smaller loans ranging between $5,000 to $500,000.
How long do you need to be in business before you can take out a loan?
Ideally, the minimum amount of time a person needs to be in business before they can take out a sizable loan is two years, although this might be different from lender to lender. Microlenders or online lenders might have more favorable conditions, which might provide financing to newly founded businesses.
Can a new business be approved for a loan?
Though the minimum requirements may vary across lenders and loan products, it’s best advised that a business owner take time to build a more favorable financial structure for their business before taking out a loan. This might include things such as building a credit score, opening a credit card account, raising capital for collateral, or repaying any form of existing debt.
How much revenue should my business make before I can take out a loan?
Business owners looking to take out a larger loan with a lower interest rate and more tailored services will typically need to prove that their business generates around $100,000 in annual revenue. This, however, is only an average amount, and some lenders may require you to prove to have a higher level of annual revenue. The better your company’s topline, the higher the chance you are of being approved for a business loan.
Finishing Thoughts
Taking out a business loan can be a big responsibility, and every entrepreneur or existing business owner must understand the various facets of the process and what may be required of them to be approved for a loan.
Investing in the proper resources, and acquiring the necessary documentation beforehand can help smooth out the process. More importantly, it’s important to already have a firm understanding of how business loans work, and what are some of the underwriting agreements you will be required to fulfill.
Although taking out a business loan can increase your business debt, it does provide you with the necessary capital to fund additional projects, expand your operations, and pay for day-to-day costs such as payroll or suppliers. By being smart, and making the right choices, you can ensure that a business loan helps uplift and grow your business.