5 Things to Know About Small Business Loans
Managing cash flow is one of the biggest challenges when running a growing business. Cash flow gaps occur in every small business.
When this happens, many turn to small business loans to secure capital. This process can be daunting and difficult to navigate.
This article will provide you with the five things you need to know about small business loans. We’ll break down the different types of loans and teach you what to look for in a small business loan.
You’ll also learn about several alternatives that you can take advantage of if a small business loan is not your best financing option.
5 Things to Know About Small Business Loans
There are certain things that every small business owner should know before heading down the application process.
Here are the five main facts to know:
- They’re all different.
- Being prepared helps you get approved.
- There are a lot of scams.
- Know your debt service coverage ratio.
- Be ready to back your business.
Let’s get started:
1. They’re All Different
Small business loans are as diverse as the small business owners that apply for them. Not every loan company works in the same manner, and even within the same lending company, you’ll find various types of loans.
Each lender has their own formula for setting loan terms. They’ll all offer different amounts of money at different rates, and they’ll all require a different credit score.
With the diversity of loans available, it might be overwhelming to try to find the best loan for you. The best tactic is to focus on what you need and find a loan that matches that need.
2. Being Prepared Helps You Get Approved
Instead of walking into a bank and winging it, consider approaching the application process as you would a job interview.
You will be representing your business and stating your case as to why the lender should consider you worthy of a loan.
This takes some preparation on your part. You will need to have a solid business plan and a detailed explanation of how you will use the money.
It also helps to include how this money would help you grow your business’s annual revenue. Anything that would give potential lenders confidence that you’ll repay the loan is worth the effort.
Don’t forget to dress professionally and to perfect your pitch in person and in writing, just in case they require an online loan application.
The big wigs in the banking industry want to see numbers, but they are human (mostly) and can be won over by a good personality and way with words. Practicing your negotiation skills can be the key to getting the loan you need.
It’s always good business to highlight your strengths and provide concrete numbers to back up your claims.
3. There Are A Lot of Scams
Online lending provides more businesses with the ability to secure funding but also subjects them to increased risk. As with any other type of online service, you are at risk of falling prey to a scam.
Before signing any paperwork online, do your research to ensure you are borrowing from a legitimate lender. As the old adage says, “If it sounds too good to be true, it probably is.”
Also, don’t forget to read the fine print. This can be an easy place for companies to slip in extra fees or clauses.
4. Know Your Debt Service Coverage Ratio
Potential lenders are going to look at your debt service coverage ratio, or DSCR. You can calculate yours by dividing your net operating income by the total debt service (the total amount you’d pay toward the principal and interest).
If you have a cash flow of $5000 per month and your loan payments would be $2500, your DSCR is 2 because your loan payment is half your income.
Most lenders want a DSCR score higher than 1.5.
Needless to say, the higher your DSCR, the better your chances of getting the loan.
5. Be Ready to Back Your Business
Some lenders want to see an entrepreneur ready to guarantee the loan with their personal assets.
Not only does this show that you believe enough in your own business to put your assets on the line, but sometimes the business doesn’t have enough collateral to cover the loan amount.
If you want others to risk their finances for your business, you should be ready to risk your own.
Types of Small Business Loans
As we discussed above, small business loans vary widely in amount, interest rates, and eligibility criteria. This is especially true when you are looking at the different types of loans available to you.
Here are several of the most common types of small business loans:
SBA Loans
The U.S. Small Business Administration created this loan program to help create more business opportunities in the country and, in turn, promote a better economy. The U.S. government backs the loans, so the terms and rates are typically very good for small business owners.
To apply for an SBA loan, you need to visit their website and follow the directions. You’ll find most of the necessary forms on the site, but you will need to find an SBA-approved lender to complete the application process.
The SBA offers several different types of small business loans:
7(a) Loans
This is the most popular loan for small businesses due to the fact that it can be used for almost all business needs and has great terms.
The 7(a) Loan Program has a capped interest rate and promises the lowest possible fees. The maximum amount you can borrow is $5 million.
504 Loans
504 loans are fixed-rate loans offered to help businesses with equipment financing. You can only use them for the repair of machinery or upkeep of real estate.
Microloans
These are smaller loans (less than $50,000) that can be used for startups or expansions on existing businesses.
PPP Loans
These loans are no longer available. But, during 2020 and 2021, the SBA’s Paycheck Protection Program helped thousands of small businesses survive the effects of the coronavirus pandemic. The PPP enabled companies to continue to pay their employees and keep the daily activities of business running.
Term Loans
Small business term loans are traditional loans that are paid back in fixed monthly payments. The term length can be short, medium, or long-term depending on the need and amount borrowed.
These loans are usually secured by business assets. Recipients have the freedom to use these funds for whatever business needs they see fit.
Working Capital Loans
A working capital loan is a short-term loan to help the business stay afloat when capital is short.
These loans can be used to pay payroll, business expenses, or debt.
The application process for this type of loan is fast, and you don’t need credit to receive one. However, you need to be aware that you will be expected to pay the loan back in full rather quickly (usually less than 12 months).
Related: The How-To Guide to Working Capital
Business Line of Credit
This type of loan is similar to a personal credit card, but it comes in the form of a separate bank account for your business.
A business line of credit gives you some money to draw from when you need it, and you don’t have to pay it back unless you use it. It is very flexible but usually comes with a higher interest rate.
What to Look for in a Small Business Loan
When shopping around for a small business loan, there are a few different things that you should keep your eyes and ears open for.
Let’s break down these elements of a loan and how the different types of loans rank for these factors.
Speed of Funding
In the business world, time is money. The longer you have to wait to receive your financing, the worse your financial situation can get.
If you are in dire need of money to keep your business afloat, the speed of funding should be one of the top priorities in your choice of financing.
The fastest method of business funding is a merchant cash advance. You can get this loan within hours of filling out the loan application, but the interest rates can be very high.
As fantastic of a deal as SBA loans are, this is where they fall short. SBA loans can take months to process. This can wreak havoc on a small business that needs quick financing.
Cost
There’s no such thing as a free loan.*
However, there are some loans that will cost you less money in the long run. If you want to save money on your financing (who doesn’t?), you’ll need to choose your loan option wisely.
SBA loans are definitely the least expensive small business loans. These loans are backed and regulated by the government to provide a more cost-effective loan option for entrepreneurs.
With other types of loans, prices range, and it’s up to you to find the right one for your business.
Of course, if you already have a small business loan but you find a loan with better terms, refinancing is a smart move. It can save you hundreds or even thousands over the span of a few years.
*Free business money is called a “grant,” and there are many opportunities for small businesses to receive grants. Learn more in these articles:
Term Length
For some businesses, it’s not the overall cost that matters most, but how much they are expected to pay each month.
The longer the term length, the smaller your monthly payments.
The type of loan with the shortest term length is a merchant cash advance. These loans can be due within a few months to a little over a year (but again, they have very high interest rates, and we don’t recommend them for that reason).
On the other hand, a traditional term loan can last up to twenty years, so you could be making monthly payments for decades.
Credit Needs
With almost all financial lending, your creditworthiness is taken into account.
Just as a personal loan lender would look into your personal credit score, business loan lenders will look at your business credit score.
If your personal and business credit report meets the SBA’s requirements, you should be eligible for term loans and SBA loans.
If you have bad credit or little credit history, your best bet would be to try for a working capital loan. You may also be able to increase your eligibility for other loan types by offering a hefty down payment upfront.
Type of Bank
Your odds of approval are also dependent on the type of bank you are lending from. Each lending institution has different eligibility qualifications.
Even within the different types of banks, each branch can have specific requirements. Check their FAQ page on their website, as this is often the place that lists the loan requirements.
Big banks usually have stricter requirements, making it more difficult to secure funding. However, they can usually offer better rates, and you’ll know that you are borrowing from a trusted source.
Small banks may be more willing to lend to businesses in their hometown since they know the company and the business owner. They can also offer pretty good rates.
Credit unions aren’t usually big enough to offer competitive rates, but if you are a member, you may be able to take advantage of special financing options.
A relatively new contender in the small business loan department is alternative or online lenders. Many online lenders have a faster application process, but they often charge higher rates.
Alternatives to Small Business Loans
No matter what type of small business financing you choose, securing a loan is no easy task.
Not to mention, it can be stressful to consider how difficult and lengthy the repayment of these loans can become. No one wants to accumulate business debt.
If you are wary about committing to a small business loan, you do have some business financing options that are a little bit easier to secure (and sometimes more cost-effective).
Invoice Factoring
This is more of a business strategy than a financing option. In order to have a more stable cash flow to rely on, you can sell your accounts receivable to a third-party company. It’s an easy way to get instant access to working capital!
Credit Cards
Business credit cards are always a viable option if you want to make a big purchase or only need a few thousand to make ends meet.
Of course, they do have their downfall:
Credit cards normally have higher interest rates than traditional loans, and some even have annual fees attached.
There are a few that break the mold, offering cashback and rewards programs that make their services a worthwhile option.
Investors
Many business owners turn to investors to help out with financing. Investors provide a set amount of capital in exchange for a portion of future profits.
Related: 5 Things to Do Before Bringing in Outside Investors
In all aspects of business, the more informed you are, the better. Hopefully, after reading this article, you feel like you know enough about small business loans to make confident decisions regarding business financing options.
Ultimately, you should acquire whichever type of loan best meets your business’s needs. Granted, you may not even need a loan at all.
If your working capital is tight simply due to unpaid invoices in accounts receivable, you can have your financial situation resolved by opening an account with Now.
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