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Small Business Loans: How They Work and What You Should Know

Many business owners have flirted with the idea of getting a loan but got discouraged prematurely or overwhelmed by the deluge of information they found online. In this  | article, we’ll keep it simple. Let’s look at the basics of small business loans and the most important things you need to know about them.

How do small business loans work?

There are many kinds of business loans, so the specifics vary, but in general, the process starts when the borrower submits a loan application. The lender then evaluates the application against a certain set of requirements. If he is not sure that the borrower can pay back the loan on time, he rejects the application. Otherwise, he approves the loan and the lender and the borrower iron out the details and formalize the agreement through a contract. The borrower then receives the money after a certain period and has to repay the loan plus interest through regular payments within the timeframe indicated in the contract.

Let’s look at common kinds of small business loans to make things clearer

1.      Traditional business loans

A traditional business loan, such as a bank loan, is hard to qualify for, but it allows the business owner to borrow a large amount with a low interest rate (such as 7%), and to pay back the money within a few years, which makes the monthly loan payments manageable.

2.      SBA loans

A Small Business Administration (SBA) loan is similar to a bank loan, but partially guaranteed by the US government. Because a big part of this loan is backed by a government agency, the lenders see the loans as low-risk and borrowers thus get very favorable terms, such as low interest rates and long repayment periods, which lead to affordable monthly payments. The amount you can borrow depends on the type of loan you’re getting.
There are multiple kinds of SBA loans, depending on how much you need and what you will use the money for:
SBA 7(a) Loan — The most popular type of SBA loan. You can borrow up to $5 million and the funds can be used for most business purposes.
SBA 7(a) Express Loan — a quicker source of funding for borrowers who need less than $350,000
SBA CDC/504 Loan — can only be used to buy owner-occupied commercial real estate or other fixed assets
SBA Microloan — for business owners who need $50,000 or less

3.      Short-term loans

Unlike with bank loans and SBA loans, business owners can only borrow a smaller amount from short-term lenders. The interest rates are significantly higher, though, and the repayment term typically only lasts from a few months to a little over a year.
On the upside, these alternative lenders are typically less strict than traditional lenders when it comes to their requirements, such as those related to the borrower’s credit score or how long the borrower has been in business. The application process for short-term loans also tends to be faster and more convenient, and the funds are released quicker.

4.      Other funding sources

There are other funding options that are technically not loans, but advances. These function like loans, nevertheless, as the lenders provide small business financing that you have to pay back with interest. Examples are merchant cash advance and invoice factoring.
With merchant cash advance, the lender provides you a cash advance, then takes a portion of your credit card sales each day until the advance and its interest are paid in full. With invoice factoring, meanwhile, you get a cash advance that amounts to a big portion of your outstanding invoices. The lender then collects the payment from your customers once the invoices are due.

Important Things to Know about Small Business Loans

  1. Getting a business loan is not just for companies that are having financial problems. While some business owners borrow money to take care of cash flow issues, many entrepreneurs use business loans to address seasonal needs, buy additional equipment or inventory, or expand their companies’ operations.
  2. If you want the most affordable loan, you will have to work for it. In terms of affordability, conventional business loans and SBA loans are your best bet. Because of their low interest rates and long repayment periods, however, they are popular among borrowers, so competition is tight. In addition, they have strict requirements and you will have to submit a lot of paperwork and wait for weeks or even months for a decision. Some entrepreneurs even had to try multiple times just to get approved for a bank loan.
  3. Be specific. Have a clear idea of how much you need and how you will spend the money. Thinking these two points thoroughly will help you determine the amount that is enough to serve your needs, but not too much that you would be paying interest on surplus money. In addition, being specific can give lenders the impression that you have a definite plan and will use the funds wisely to grow your business.
  4. Different lenders have different requirements, so don’t get discouraged if one lender rejects your application. If possible, figure out why you were turned down, so you can fix the problem before you apply for another loan.
  5. The best funding option for your business depends on several factors, such as how much money you need, your personal and business credit scores, your business revenue, and the age of your company.
  6. You can still get a small business loan even if you have bad credit. You may not qualify for a bank loan but there are many lenders who are willing to finance people with mediocre or bad credit, as long as you can show that your business is profitable or that you have collateral to back your loan.

It is important for business owners to be knowledgeable about small business loans, as access to additional funding can help you grow your business or improve any cash flow issues you are experiencing. Getting a loan is not always easy but can make a big impact on the success of your company.