What is a Small Business Loan? A Comprehensive Guide

A small business loan may be just what you need when looking to expand your business. With a small business loan, you can either build your business from scratch or take it to the next level of growth. 

What is a small business loan?

A small business loan is a type of funding that can be granted by a traditional bank, online lender, or credit union. It is usually lent in the form of cash, which the business can use for specific business-related reasons or at their discretion, depending on the agreement made with the lender. 

How do small business loans work?

The small-business owner must first place a loan application with the bank or lender to obtain a small business loan. This entails providing precise information and meeting the lender’s requirements, which we’ll cover later in this article.

In short, once the application is approved, the business owner is provided with a lump-sum of cash or a business line of credit. Along with this form of funding comes an agreement on a fixed repayment plan/ schedule, including interest on the entire loan.

As the business owner, you are required to pay back the loan in full over time. Make sure to ask about financing options as well as the repayment frequency. Some lenders require loans to be paid back within a certain time frame, and payments can be daily, weekly, or monthly.

Doing some prior research on specific lenders and understanding how their loans work will save you a lot of time and energy regarding application time.

What can a small business loan be used for?

There are many reasons for needing a business loan. Most commonly, small business loans are used for:

• Startup costs 
• Working capital
• Purchasing heavy machinery or large equipment 
• Building out or remodeling a business space 
• Marketing and advertising
• Maintaining inventory 
• Paying employees 
• Purchasing real estate
• Managing daily expenses
• Brand expansion

To sum it up, loans can be used for almost any business-related reason. Lenders will not allow a small business loan to be used for personal reasons; if a lender gets wind of that happening, they have the right to revoke the loan. 

What are some types of business loans? 

• Business line of credit
• Equipment financing
• Invoice factoring
• Merchant cash advance
• SBA loans
• Term loans
• Working capital loans

Business line of credit

A business line of credit can be a good small business financing option when you are unsure how much money you will need upfront. 

The benefit of this type of funding is that borrowers can access anywhere from $2,000 to $250,000 at their leisure, and it works the same way as a personal credit card. 

One pro to having a business line of credit is that once you pay down the balance, it frees up more credit funding. 

Another plus is that you will owe interest on the amount you spend, not the entire credit line amount, like a term or SBA loan. 

Usually, a business line of credit will allow for a draw period of 12 to 24 months, and sometimes even interest-free. Once that period ends, you must pay back the balance monthly with interest. In some cases, once this period is over, you may no longer access the credit line.

Equipment financing

One major reason that small businesses need a loan is to finance heavy machinery or large equipment needed to get the business up and running. These items include laptops, computer systems, furniture, kitchen appliances, etc. 

When using this specific type of funding, loan amounts are granted based on the cost of the equipment. In most cases, lenders will grant 80% to 100% of the funding needed for the purchase but may ask for a downpayment of 5% to 15% upfront.

Equipment financing loans typically have a term of three to 10 years and will require a repayment schedule like a traditional business loan.

Invoice factoring

Invoice factoring is a financing option that allows businesses to sell their outstanding invoices to a factoring company. The factoring company will front you a portion of the uncollected invoices (70% to 90%) and become responsible for collecting the outstanding invoices from billed companies. This works like a collections agency. 

When invoice factoring, remember to keep in mind that this funding comes with fees that can range from 0.5% to 5% each month for all unpaid invoices.

This type of funding can be a good option if the business is a startup or does not have a strong, qualifyingcredit history and is most likely unable to receive a business loan.

Merchant cash advance

A merchant cash advance or an MCA can be a good option when your small business needs cash fast. This works because the borrower will provide the lender with a portion of future sales receipts in exchange for a lump sum of cash. 

This type of funding almost always includes fees. The fees and the amount borrowed are expected to be repaid through the business’s sales profits with daily or weekly payments to the lender.

One downside of this type of funding is that because the cash is given in hand rather quickly, the fees usually cost between 1.2% to 1.5%. For example, if the MCA amount is $20,000 with a rate of 1.2, the total payback would be $24,000.

MCA financing is a good option if a business brings in high sales volumes daily and has difficulty getting approved for a traditional small business loan.

SBA loans

An SBA loan is guaranteed by the government and backed by the Small Business Administration, which works with a network of lenders. This specific loan has many benefits and takes a longer approval due to its many qualifications. Since the government backs this loan, there is less risk on the lender’s end, ensuring lower interest rates.

An SBA loan range varies from as little as $30,000 to as much as $5 million for more qualified businesses with extended repayment terms. 

An SBA loan can be a good option for businesses that may not have the best financial standing and are willing to wait longer for the application process. Approval time typically can take up to three months. 

The qualifications and requirements can be more extensive, and sometimes lenders will also look into the business owner’s personal credit history and character as a qualification.

Term loans

A small business term loan is a widespread financing solution for your small business and must be repaid over time. A term loan is a short-term, one-off loan usually used for, but not limited to, covering one-time expenses.

With this loan, you are granted a lump sum of cash after application approval and are expected to repay the loan in installments that the lender sets. In most cases, lenders will require weekly or monthly payments, which include interest on the loan.

Term loans can cover $50,000 up to $5M, depending on your qualifications and proven steady business income.

Working capital loans

A working capital loan is a loan that is used specifically to cover a business’s everyday expenses and needs. Still, this specific type of loan is not used for big, one-time purchases or long-term investments; it can be used for paying employees, purchasing inventory, rent, debt payments, etc. 

The caveat of working capital loans is that they are usually granted based on the business owner’s credit report. So by taking this loan, you are personally responsible for repaying it, and failure to do so can damage personal credit.

Some working capital loans include a business credit card or line of credit, term loans, or invoice financing.

Some benefits of working capital loans are that they are easier to obtain than a traditional business loan. Another pro is that it is a form of debt financing which allows a company to build credit rather than equity transactions.

Some working capital loans are also unsecured, meaning a business does not need to provide collateral to obtain the loan. Usually, only companies with high credit reports and credit scores are eligible for an unsecured loan, so be sure to understand the conditions ahead of time.

Small business loan summary

Many options are available when looking for funding for almost any business need. The first step is deciding what you need financing for. You then need to research the types of funding that will work best for you and your business.

If you want to start up or expand your business, go to entrepreneur.com. We have the answers you need.