Key takeaways
- Small business loans work by giving you money to use for business purchases that you then repay over a set term with interest
- Approval for a small business loan typically requires a good credit score, solid business revenue and a personal guarantee or collateral
- There are many types of business loans to choose from, including term loans, SBA loans, equipment loans and more
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. Small business loans work by giving you a lump sum of cash that you then repay with interest over a set time period.
Small businesses have access to many loan options from a variety of sources, and each type works slightly differently and can go toward different purchases. Before you sign for a loan, it’s important to research different types of loans and lenders to make the best decision for your business.
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?
Small business loans work by borrowing money from a lender and then repaying the amount borrowed over a set period, including 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, while an unsecured loan does not. Loan collateral might be equipment, real estate or other business assets used to back the loan. If the borrower fails to repay or defaults on the loan, the lender can take possession of the collateral to cover the borrowed amount.
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.
Here’s a closer look at how a few popular types of business loans work.
How do 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 short, limiting terms to 24 months or less, or long allowing you to pay back the loan in up to 10 or more years. Short-term loans help you pay off the loan quickly, while long-term loans offer lower monthly payments that stretch out the cost of the loan over a long time.
Typically long-term loans are reserved for borrowers with strong credit and finances because these borrowers are likely to repay the loan in full. Keep in mind that the longer your term, the more you pay in interest over that term.
How do SBA loans work?
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 a particularly 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.
How do business lines of credit work?
Business lines of credit offer a flexible borrowing option that the business owner can reuse as needed, much like a business credit card. The lender sets a credit limit, which is the maximum amount the business owner can borrow.
You can then draw from the credit limit when you need the funds, only paying interest on the amount borrowed. As you pay back the loan, the credit limit refreshes, allowing you to borrow more funds in the future.
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 8 percent but may go up as much as 60 percent, depending on your creditworthiness.
How do invoice financing and invoice factoring work?
Invoice financing and invoice factoring are both short-term financing that use your unpaid invoices to secure the loan. With invoice financing, the accounts receivables are used to determine the amount of your advance, up to 90 percent of your invoices. Once your client pays the invoice, you must repay the lender for the money you borrowed. You will also pay any fees for the loan.
Invoice factoring involves selling your business’s unpaid invoices to a third-party invoice factoring company. The factoring company advances you a portion of the invoices and then collects the invoices directly from the client. Once your client pays the invoice, the lender sends you the remaining amount after subtracting lending fees.
Both invoice financing and factoring can be valuable options for business owners with bad credit or for startups that do not have much of a borrowing track record yet. They weigh your clients’ track record of payments more than considering your business’s credit score and finances. The downside to this level of accessibility is that these loans tend to cost more than term loans and lines of credit.
How do merchant cash advances work?
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 are typically a short-term form of borrowing offered by online lenders. And often, you’ll pay a higher APR on cash advances than 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 MCAs may be possible with subprime credit, sometimes as low as 500. But to qualify, you’ll need to provide details about your business and its track record of income from credit and debit card sales.
Types of small business loans
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.
| Loan type | Purpose | Best for |
|---|---|---|
| Term loans | Working capital, equipment or business expansion | Large, one-time expenses |
| SBA loans | Working capital, payroll, expansion, equipment, real estate and large equipment | Businesses that want low-interest rates and the options for longer repayment |
| Business lines of credit | Payroll, supplies, inventory, working capital and other small or recurring expenses | Businesses that need flexibility with their borrowing |
| Equipment loans | New or used equipment, including vehicles, medical devices and machinery | Businesses purchasing new or used equipment |
| Invoice factoring/Invoice financing | Working capital, payroll, inventory and supplies | Businesses with unpaid invoices that need to cover cash flow gaps until they receive payment |
| Commercial real estate loans | Commercial real estate purchase or lease | Businesses looking to open up a physical location |
| Microloans | Inventory, supplies, working capital or business expansion | Startups or businesses that need a small amount of funding |
| Merchant cash advance | Working capital | Businesses with credit or debit card sales that can’t qualify for other financing |
The bottom line
If you’re considering launching a small business or the time has come to expand operations, a small business loan could 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.
