What are small business loans and how do they work?

If you have a new business or are ready to take your business to the next level, a small business loan might be your next step. There are many different types of small business loans, by they typically work by giving you a lump sum of cash that you then repay with interest over a set time period.

Learn more about how small business loans work and the different types of loans to help you choose the right option.

How do small business loans work?

With a small business loan, you typically borrow money from a lender and then repay the amount borrowed over a set period, plus interest and fees. You can use the loan for a variety of purposes in your business, including to cover operational costs, buy equipment, stock up on inventory or hire employees.

Businesses considering a small business loan can choose between secured and unsecured business loans. A secured loan requires you to put down collateral — such as real estate, equipment or other business assets — that can be used to cover the loan amount if you default on the loan.

While unsecured loans don’t require collateral, they often require a personal guarantee, meaning you and other business owners pledge personal responsibility for repaying the debt if the business can’t.

Types of small business loans and how they work

How you plan to use your business loan impacts the type of small business loan you choose. For some business owners, the funds may be used to cover day-to-day operations, while others are interested in purchasing equipment or vehicles.

The below common types of business loans have varying loan amounts, interest rates, fees, eligibility criteria, possible uses and repayment terms.

Here’s a closer look at how a few popular types of business loans work.

Term loans work

Term loans provide a lump sum of cash that is paid back over a set period of time. The terms can be as short as six months or up to 25 years, depending on the lender and specific loan purpose.

Short-term loans help you pay off the loan quickly and potentially save money on interest, while long-term loans offer lower monthly payments that stretch out the cost of the loan over a long time, though you’ll likely pay more in interest.

SBA loans

SBA loans are business loans that are partially guaranteed by the U.S. Small Business Administration. These loans are known for having low rates and long repayment periods, making them an affordable borrowing option. But they can take 30 to 90 days to receive and have strict qualification requirements. Often, these loans require a good credit score and solid business revenue.

For example, many lenders like Live Oak Bank require a solid credit score of at least 650 to apply for its SBA loans. But there are some lenders that lower credit requirements, such as Creditfy that requires only a 600 credit score for SBA loans.

To get an SBA loan, you apply through an SBA-approved lender. This will require extensive documentation, including personal and business financial statements, a business plan and SBA-specific forms, such as SBA Form 413. Most SBA loans also require a down payment and personal guarantees.

Business lines of credit

Business lines of credit offer a flexible borrowing option that you can reuse as needed, much like a business credit card. The lender sets a credit limit, which is the maximum amount you can borrow, and you can continue borrowing up to that limit as you pay down your balance. You only pay interest on the amount you’ve drawn.

Funds from a business line of credit can be made available relatively quickly, often within a business day, when working with an online lender. The money can cover business expenses, such as paying employees or purchasing inventory. But lines of credit typically come with smaller funding limits than traditional business loans, so they may not be able to cover significant expenses or funding needs.

You may also pay higher interest rates on a line of credit than other types of loans. Rates can start at eight percent but can reach as high as 60 percent, depending on your creditworthiness.

Invoice financing

Invoice financing is a type of short-term financing that uses your unpaid invoices as collateral on a loan. Your accounts receivable are used to determine the amount an invoice financing company will loan you — usually up to 90 percent of your invoices. Once your client pays you, you repay the lender, plus fees.

Invoice financing can be a good option for startups or borrowers with bad credit because the focus is more on your clients’ payment history and credit than yours. However, it can be an expensive form of financing, so it’s best to understand what you can afford before you proceed.

Alternatives to small business loans

Invoice factoring and merchant cash advances (MCAs) are both alternative financing options that are not technically loans. With invoice factoring, you sell your unpaid customer invoices to a third-party invoice factoring company at a discount. The company then takes over collecting on the invoices from your customers.

A merchant cash advance (MCA) is an advance against your business’s future sales, specifically debit and credit card sales. The advance is provided in a lump sum of cash, which you repay with a percentage of your future sales, such as 10 percent or 20 percent. The lender will also take its fees from your future sales.

MCAs and invoice factoring are typically short-term forms of borrowing offered by online lenders. And often, you’ll pay a higher APR than with other types of business loans. It’s possible for interest rates to soar into the triple digits with MCAs, so business owners should proceed carefully before seeking out this type of business financing.

Approval for both MCAs and invoice factoring may be possible with subprime credit, sometimes as low as 500.

The bottom line

Whether you’re considering launching a small business or expanding your current operations, a small business loan can provide the money needed to achieve your goals. When considering the right loan option for you, it’s important to research different types of loans and how they work. Then, you’ll be ready to compare lenders to find the best small business loan for you.

Frequently asked questions

• How hard is it to get a business loan?

  How hard it is to get a business loan depends on the type of business loan, the lender and your business’s qualifications when applying. For example, many bank loans and SBA loans have strict qualification requirements, while equipment loans and loans offered by online lenders may be more lenient.

• How do I take out a business loan for the first time?

  To take out your first business loan, you first want to research different types of business loans that fit the purpose of your funding. You’ll also want to determine how much funding you need and how much you can afford.

  You can use a business loan calculator to estimate monthly payments on a loan. Next, you’ll need to research lenders and, if possible, prequalify with several to see what loan, interest rates, fees and terms you qualify for. Then, compare loan options and apply for your preferred business loan.

• How much collateral is needed for a business loan?

  Typically, lenders require that the collateral used to secure the loan equals to 100 percent of the loan amount. If you take out a secured business loan, the value of your collateral should equal the amount you plan to borrow.