How do Business Loans Work?

How do business loans work?

A business loan is an amount of money a business borrowers from a financial institution, with set requirements for the amount of time it will take to pay back, as well as interest rates. Businesses get loans in order to help them start or to fund expansion. They’re one of a range of funding options for startups.

Here’s a look at how business loans work, starting with the types of business loans that are available to startups and right through to how to apply for a business loan.

Types of business loans for startups

There are five main types of business loans that are relevant for startups: SBA small business loans, business credit lines, short term loans, invoice financing, and merchant cash advances. Let’s take a closer look at each one.

SBA Small Business Loans

A SBA small business loan is a loan that is backed by the Small Business Administration (SBA). Founded in 1953, the SBA is a federal government program that provides support to small business owners in the form of mentorship, workshops, counseling, and small business loans.

While the loans are backed by the SBA, they don’t come directly from the SBA. You’ll have to find a local lender who provides SBA loans in order to access to the funding.

Who qualifies?

There are three main types of SBA small business loans:

• 7(a) Loan Program
• 504 Loan Program
• 7(m) Microloan Program.

Each type of SBA small business loan has slightly different requirements, but generally you have to qualify as a small business according to the SBA size requirements, be a for-profit business, operate within the United States, have good personal and business credit, and not have other financing options (like your own wealth).

Loan amounts

SBA loans have an upper limit of $5 million. Therefore, they’re a better option for small businesses and startups who need smaller amounts of capital, versus those who might need many millions of dollars.

Time to funds

The process for applying for a SBA loan can take up to six weeks, with some taking only a couple weeks. If you qualify for a SBA loan, you can expect your funds as soon as one week after qualifying.

Interest rates

As of May 2018, maximum interest rates on SBA loans range from 7% to 9.50%.

Pros of SBA loans

• The loan is backed by the federal government. That means banks are more likely to loan to riskier companies — like startups — than they might otherwise.
• The equity requirement is relatively low compared to other loans.
• SBA loans have a floating interest rate that’s tied to the Prime Rate. The maximum interest rate for these loans is Prime Rate plus 2.25 percent for loans maturing in 10 years or less, and Prime Rate plus 2.75 percent for loans maturing in 25 years.
• People and companies who don’t have access to other forms of capital might find it easier to qualify for a microloan than for a larger or more traditional loan type.

Cons of SBA loans

• SBA small business loans are relatively small. They have an upper limit of $5 million.
• These loans may require more paperwork than a traditional loan.
• Startups or founders with poor credit are unlikely to qualify.

How to apply

If you’re interested in applying for a SBA loan, you can check out the SBA website to find a financial institution in your area that provides SBA loans. You can also learn more about SBA loans in our full guide.

2. Credit cards

While not a traditional “loan,” business credit cards are a great option for very early stage startups who need help getting going.

Choose one with a 0% introductory APR, because that means that as long as you’re able to pay off the balance each month (or at least by the end of the first year, which is when most credit cards interest rates kick in), you’re basically getting a free loan.

However, beware of high interest rates — and don’t overestimate how quickly you’ll be able to pay back a credit card. Once that introductory period is over, any balance you’re carrying will likely come with a hefty interest rate.

a. Who qualifies?

Credit cards usually have very few requirements for qualification. Banks are in the business of profiting off of small businesses. (While, yes, helping them grow.)

However, people with bad personal credit will find it difficult to qualify for a business credit card, as most banks are going to look at your personal credit to determine whether or not they’re willing to give you a credit card for your new business or startup.

Most banks use the FICO scoring system, which is:

• Excellent Credit: 750+
• Good Credit: 700-749
• Fair Credit: 650-699
• Poor Credit: 600-649
• Bad Credit: below 600

Check your credit rating with one of the big three credit agencies before starting the process of applying for a first time business loan.

b. Loan amounts

The loan amount — or credit line — that you can get with a credit business card depends totally on the type of card, your personal credit history, your business credit history (if you have any), and your business itself.

However, the highest business credit limit right now probably tops out around $50,000.

c. Time to funds

Unlike other sources of small business funding, credit cards are very quick to apply for. Once you’ve been approved, you can expect to have your card in hand within seven to 10 days.

d. Interest rates

Interest rates vary from card to card. As mentioned above, it’s a good idea to go for a card that has an initial 0% APR (annual percentage rate). That way you have a year without any interest whatsoever.

As of April 2018, the common APRs offered online for business credit cards was 14%, which is about 2.5 points lower than average for personal cards.

e. Pros of business credit cards

• They’re easier to get than other loans or lines of credit.
• They have higher credit limits than personal credit cards.
• They can help boost your credit rating.
• It’s easier to keep personal and professional expenses separate.
• You can build up points that can be used for travel and other perks.
• It’s easier to keep track of employee spending, if you have employees, and some even offer preset employee spending limits.
• It helps build credit history for your business.

f. Cons of business credit cards

• If you have trouble making payments, it may affect your personal credit.
• High interest rates, late fees, and annual fees can add up and be brutal.
• Many business cards don’t have purchase protection.
• Business credit cards often have a higher APR than personal cards.
• Interest rates can fluctuate.
• A business credit card may come with foreign transaction feeds

g. How to apply for a business credit card

First, get your credit score so you can determine which business credit cards you even qualify for. You can get it from one of the big three credit agencies.

Once you have that, calculate your business’ annual revenue — the credit card agency is going to want to know that information.

Decide what kind of rewards program you want, and then go take a look at different business credit cards to see what’s the best fit.

Maybe make a spreadsheet of the factors most important to you — like APR, credit score needed, limits, rewards, signup bonuses, etc. — in order to do a side-by-side comparison.

Then, apply via the card’s website. That’s it! If you’re rejected for your first choice move on to the next. There are plenty of options out there.

Here are some of Credit Karma’s best recommendations for Business Credit Cards and Business Loans.

Short-Term Loans

Short term loans relatively small amounts of money that have to be paid back within three to 18 months.

They’re often used as a stop-gap when a company is having cash flow problems, for emergencies, or to help companies take advantage of a business opportunity.

a. Who qualifies?

Short term loans are a good option for startups with good cash flow who have been in business for at least two years. If your startup has good cash flow, it may even override other factors like poor credit. Therefore, a short term loan might be a good first time business loan option for founders with poor credit.

Companies who make between $25,000 and $150,000 yearly, with a credit score of at least 600, and who have been business for at least two years may consider this option.

b. Loan amounts

Short term loans are usually between $2,500 and $250,000.

c. Terms

The loan terms for short term loans are usually between three and 18 months.

d. Time to funds

The time to funds for short term loans is extremely fast! If you qualify, you can expect access to the funds as quickly as one day.

e. Interest rates

Interest rates start at 10%.

f. Pros of short term loans

• People with less-than-perfect credit may apply.
• There’s very little paperwork required.
• Short term loans come with a set payment structure.
• They can be used for a range of purposes.

g. Cons of short term loans

• Payments have to be made weekly.
• May have higher annual costs than longer-term loans.

h. How to apply for a short term loan

Short term loan applications exist online only. You’ll need your driver’s license, a voided business check, proof of ownership of your company, bank statements, your credit score (business and personal), and your personal tax returns.

Check out NerdWallet’s list of options for companies that offer short term loans.

Invoice Financing

Invoice financing is a type of business loan that uses your outstanding invoices as collateral for a loan. The company applies for a cash advance on a percentage of payments owed, then pays it back when they get paid.

Who qualifies?
Invoice financing is a great option for B2B companies with outstanding invoices. It’s not an option for B2C companies that don’t have invoices to leverage.

b. Loan amounts
The loan amounts for invoice financing vary depending on the amount of money owed your company. However, the bank will usually offer about 85 percent of the amount owed, with the option to receive the final 15 percent later. Many institutions will also take the applicant’s credit into account when determining how much they will loan.

c. Terms
The money needs to be repaid once the customer with the outstanding invoice makes their payment.

d. Time to funds
Funds can be available in as little as one day.

e. Interest rates
Invoice financing doesn’t use interest rates, but instead charges fees for loaning you the money. Most institutions will charge a processing fee of 3 percent, as well as a “factor fee,” which is a weekly percentage owed. For example, many institutions charge a 1 percent factor fee, which means they take 1 percent out your loan out of the 15 percent held in reserve every week until the total is paid.

f. Pros of invoice financing

• Time to funds is short.
• They don’t take long to pay back.
• They can be a great way to solve a short term cash flow problem.
• Founders with not-great credit (over 600) will probably qualify

g. Cons of invoice financing

• If your clients take a while to pay you, the fees can be hefty.
• They’re not an option if your company doesn’t use invoices.

Equipment Financing

Equipment financing is a popular type of business loan for startups and companies that need to purchase major pieces of equipment. It’s fast, relatively easy, and a good option for startup founders or new business owners, as the equipment itself stands in for collateral for the loan.

Who qualifies?
Most businesses qualify for equipment financing, because the equipment stands as collateral. That means if you don’t pay back the loan, the financial institution has the right to take the piece of equipment back from you.

Founders with some revenue and less than perfect credit (over 630) can still apply.

b. Loan amounts
Loan amounts can be up to 100 percent of the cost of new equipment.

c. Terms
The loan terms for equipment financing are usually the expected life of the equipment.

d. Time to funds
Equipment financing funds can be available in as little as two days.

e. Interest rates
Interest rates for equipment financing range from 8 to 30 percent.

f. Pros of equipment financing

• Funds arrive quickly.
• There isn’t too much paperwork involved.
• Equipment being purchased serves as collateral, so it’s a good option for founders with limited revenue or not so great credit.

g. Cons of equipment financing

• Certain equipment may become obsolete before the loan is repaid.
• Some equipment depreciates over time, meaning you can’t deduct the full amount every year.

h. How to apply for equipment financing
In order to apply for equipment financing, you’ll need your credit score, as well as financial documents (like tax returns and bank statements) showing that your business is in good financial standing. You’ll also need your driver’s license, a voided check, and an equipment quote showing how much the piece of equipment you’re trying to buy is worth.

Merchant Cash Advance

Who qualifies?
A merchant cash advance is a good option for a startup or small business that needs cash now and also has customers that pay via credit card. In this type of loan, a financial institution gives a cash advance in exchange for a percentage of daily credit card transactions, plus a fee.

b. Loan amounts
Merchant cash advances range from $2,500 to $250,000.

c. Time to funds
It’s possible to receive funds in as little as two days.

d. Interest rates
Merchant cash advances have factor fees of 1.14 to 1.18. That means

e. Pros of merchant cash advance

• Money is accessible quickly.
• The approval process is relatively simple.
• Founders and companies with bad credit may still apply.
• The money can be used for a range of different purposes.

f. Cons of merchant cash advance
The fees are higher than a normal loan. It’s the most expensive type of business loan.
Repaying through daily credit card transactions means a reduced cash flow.
You may have trouble changing merchant service providers.

h. How to apply for merchant cash advance
Merchant cash advances are almost always given online. The institution will look at your credit card processing statements and some will also ask for your credit score and banking documents.

How hard is it to get a business loan?

Unfortunately, business loans can be difficult for startups to procure. That’s because while some funding sources in the startup ecosystem — like VCs and angel investors — are looking to take big risks, traditional financial institutions like banks generally aren’t. You’re going to need to show that you have perfect personal (and probably business) credit and they might even require that you’re profitable or on track to become profitable. Generally, banks prefer businesses that have a proven track record when they’re handing out loans.

But that doesn’t mean business loans are impossible for startup founders! It’s just something to keep in mind when you’re considering a bank loan as a funding source.

Business loan requirements

If you’re trying to get a first time business loan, there’s some major prep work that needs to be done. Regardless of the type of first time business loan you decide is the best fit for your startup, you’re going to need to present the following documents and information to your lending institution. It’s a good idea to get all of this together before you approach the bank, so that you’re ready to go (and you’re sure you qualify) before you start the long process of applying and qualifying for a first time business loan.

A Personal Background Document

Your bank is going to want to know a lot about you in order to decide whether or not they’re going to loan to you, so prepare a document with the following information: previous addresses, any previous names you’ve used, criminal records (if applicable), and educational background. Basically, you want to give them an overview of who you are — and show that you’re a reliable and good bed.

Your Professional Resume

You’ll also need to show them your professional history, so prepare a resume. Feel free to offer a one-page, high-level resume, as well as a more detailed one that may extend beyond the traditional one-page resume but gives a more complete picture of your professional background.

A Business Plan

You should never, ever try to apply for a business loan without a business plan already in hand. Even early-stage startups need to be able to show financial institutions that they have a roadmap they’ll be following. It’s reassuring to the bank or credit union because it not only gives them an idea of what you’re going to do with their money, but also shows that you’ve thought seriously about the issue.

Make sure your business plan includes:

• Executive Summary
• Company Description
• Problem, Solution & Market Size
• Product (How it Works)
• Revenue Model
• Operating Model
• Competitive Analysis
• Customer Definition
• Customer Acquisition
• Traction
• Management Team
• Funding
• Financials

For more information on business plans and how to make one, check out this article: What is a Business Plan: An Introductory Guide.

A Description Of How You Plan To Use The Loan

No bank is going to give you money without a description of what that loan will be used for. So figure out exactly the purpose of this loan — and be sure to take a look at the requirements for the type of loan you’re applying for — and get that down on paper.

How Long You’ve Been In The Business

While new startups can absolutely apply for a first time business loan, in general it’s easier for companies with a little history under their belt. As a result, the minimum time in business is often two years, with companies with a longer business time more likely to be approved than younger companies.

Your Personal Credit Report

Your lending institution is going to want a copy of your personal credit report in order to determine whether or not you are a good bet for lending. As the founder, your personal credit history gives a good idea of how well you’ll handle money and loans within your startup.

Most places use the FICO scoring system, which is as follows:

• Excellent Credit: 750+
• Good Credit: 700-749
• Fair Credit: 650-699
• Poor Credit: 600-649
• Bad Credit: below 600

If your personal credit is below 650, be prepared to explain why. Also, if you find a mistake on your credit report, you have the right contest it with the credit bureau. Make sure any corrections are taken care of before you approach the bank for a SBA loan.

A Business Credit Report

If your startup has a credit history, the bank will also want to see a business credit report. You can get one from D&B, Experian, or Equifax. And while most people are familiar with the personal credit score ranking, the business one is different. It ranges from 0 to 1,000 and anything over 80 is in the good range, so don’t freak out of it’s a surprisingly low number!

Personal And Business Tax Returns

Have three years of your personal tax returns, as well as three years of business tax returns (if you’ve been in business that long) prepared and ready for examination by the bank. They want this information for the same reason they want your credit scores: It gives them a good idea of your financial and business acumen.

One note: Many small businesses and startups write off a large number of things on their taxes. However, this might hurt you in a SBA loan application, as it makes it look like your startup doesn’t have a profit. If that’s the case, be prepared to explain to the bank officer why you chose to take that approach with your taxes.

Other financial documents

In addition to your personal and professional credit reports, there are some other financial documents that your bank is most likely going to want to see.

While each institution has their own specific requirements, you should have the following prepared:

Balance sheet: Your balance sheet shows the balance of what your business owes (liabilities) and what it has (assets). On the assets side, include your cash, inventory, accounts receivables, notes receivables, and your fixed assets, such as land or property. On the liabilities side, include any debts, such as accounts payable, notes payable, accrued expenses, and long-term debt.

Profit and loss statements: A profit and loss statement is a document that shows what money is coming in, a well as what money is going out — and from where it’s coming and going. Make a detailed list of your sources of revenue and expenses for the bank officer to examine.

Business debt schedule: A business debt schedule is exactly what it sounds like: A breakdown of all of your current business debt, as well a schedule for how you’re going to pay down that debt. It will help you and your bank officer determine whether or not it’s a good idea for your startup to take on more debt. It’s also useful for keeping track of your repayment schedule and your finances as your startup moves forward.

Collateral

Collateral isn’t always required for loans, but it’s worth determining and documenting what collateral you’re willing to offer, in case they ask for it. Startups in particular may be consider higher risk loans, so definitely don’t skip this step. Take a look at your assets and consider: What are you willing to give up if you default on your loan? The answer will be particular to your assets and situation, but may include anything from real estate to equipment to the company itself.

Legal Documents

Each loan is going to have different requirements for necessary legal documents, but here are a few you might be asked for:

• Business licenses and registrations
• Articles of Incorporation
• Any existing contracts with third parties
• Franchise agreements
• Commercial real estate or business equipment leases

More information about business loans

For more information about business loans, don’t miss the following guides:
First Time Business Loans

SBA Small Business Startup Loans: A Comprehensive Guide

Small Business Startup Loans: What You Need to Know

How To Apply For A Small Business Loan

Other funding sources

Don’t miss our guides to the full range of startup funding options, below.

Federal Government Grants for Small Business: What You Need to Know

Venture Capital: What It Is & Why Use It

Series A, B, C, D, and E Funding: How It Works

What is Crowdfunding?

Types of Crowdfunding: Donation, Rewards, and Equity-Based

Private Investors for Startups: Everything You Need to Know

Convertible Notes (aka Convertible Debt): The Complete Guide

Small Business Startup Loans: What You Need to Know