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If you own a business, funding is one of the most important decisions you will make. You need money to start and operate a business, regardless of the type and size you own.
Various funding options are available, and it can be challenging to select the most suitable for your business needs. Below is a comprehensive guide to help you with the different types of small business loans and the process for acquiring them.
How Small Business Loans Work
A small business loan gives small businesses access to capital to cover the cost of doing business and making purchases. Generally, the money is used for business acquisitions, renovations, real estate purchases, staffing, and much more. In the end, small business loans give businesses the money they need to operate and grow.
Types of Small Business Loans
There are different types of small business loans, and your best choice will depend on several factors.
1. SBA Loans
These loans are backed by the Small Business Administration, a government agency that gives government-backed loans. The bank lends the loan, but the SBA guarantees a certain percentage if the business owner defaults on the loan.
Unlike conventional loans, business owners can get SBA loans with low-interest rates and extended repayment terms of up to 25 years. SBA loans are usually between $30,000 and $5 million. There are different types of SBA loan programs, including:
- SBA 7(a) Loans
The most popular SBA loan program has a maximum loan amount of $5 million. These loans are long-term and have a repayment term of about 10 to 25 years.
Maximum Loan Amount
$5 million
Repayment Term
10-25 years
Interest Rates
5.5% to 11.25%
Down Payment
25% to 35%
- SBA 504 Loans
The SBA 504 loan is designed for small businesses that finance significant and long-term equipment or commercial real estate. The loan can be used to fund tangible assets like new and existing facilities, ground-up construction, and more. Hence, it cannot be used to finance inventory or working capital.
Maximum Loan Amount
$5 million
Interest Rates:
2.81% to 4%.
Down Payment:
10-20%
- SBA Microloans
With a maximum loan limit of $50,000, SBA microloans are commonly used to help small businesses start operations and grow. These loans are typically used for working capital and the purchase of machinery, equipment, and inventory.
Maximum Loan Amount:
$50,000
Interest Rates
8% to 13%.
2. Term Loans
A term loan is a type of financing paid out in lump sum, up to around $500,000, and the repayment is made over a set period. There are two types of term loans, short-term loans that can start at three months to 18 months and long-term business loans that go up to 10 years.
Traditionally, term loans are used to finance large purchases in a business. Nevertheless, these loans can still be used to finance inventory or equipment.
Maximum Loan Amount
$500,000
Interest Rates
Start at 9%
3. Line of Credit
A business line of credit is a flexible small business loan that gives you access to a set amount of money when you need it. Meaning that you can quickly access capital when you need it, until the specified period, usually five years, ends. You can repeatedly draw funds and then repay to improve your cash flow and cover your business expenses.
Unlike a term loan, a line of credit only charges interest for the money the borrower uses. When the draw period ends, you will not be able to access the revolving funds, and you will be required to enter the repayment period.
Loan Amount
$10,000 to $ 1million
Interest Rates
7- 25%
Loan Terms
Sixfive months to 5 years
4. Equipment Financing
From the name, it is evident that this type of loan is intended to help businesses buy equipment and machinery, including electronics and fixtures. In most cases, the size of the loan will depend on the value of the item and the down payment.
Loan Amount
100% of equipment value
Loan Term
Depending on the life of the equipment
Interest Rates
8% to 30%.
5. Merchant Cash Advances
This is a lump sum of cash that businesses can access, after which the advance is repaid with a determined percentage of the daily credit card sales. The advance and the related fees can also be repaid from the automatic clearing house (ACH) payments daily or weekly. Hence, this type of loan is worth considering for businesses with high volume sales and quick access to cash.
Loan Amount
$2,500 to $250,000
Loan Payment
Daily deduction from merchant account
Factor Rates
1.14 to 1.45
6. Unsecured Business Loans
As the name may imply, these are loans that don’t need security. This means that the borrower won’t need to part with their business asset to get funding. However, this loan may require a personal guarantee and has high fees and interest rates.
Loan Amount
A maximum of $100,000
Loan Terms
Up to 7 years
Interest Rates
4% to 36%
7. Business Acquisition Loans
Businesses that want to purchase another company can qualify for the business acquisition loans. With a maximum loan amount of up to $5 million, this loan will let you buy or expand a franchise or even buy out a partner.
Loan Amount
Up to 5 million
Loan Term
Maximum of 25 years
Interest Rates
3% to 10 %
Steps for Choosing a Small Business Loan
There are guidelines to follow when it comes to applying for a small business loan.
1. Determine the Right Type of Loan for Your Needs
Before you make a loan application, determine the type of loan you need. Consider your business needs and how much you need to borrow to determine which type of loan to apply. Also, you will want to keep in mind that some lenders may restrict loans to various industries.
2. Understanding Your Credit profile
An important tip when applying for a small business loan is to understand your profile. Lenders typically consider the borrower’s credit score to determine whether they qualify for the business loan.
An SBA loan has stringent requirements, and you will need a score of about 680 to qualify. You will also need a score of at least 630 for a business line of credit or equipment financing, 600 for short-term funding, and 550 for merchant cash advances.
3. Determine Your Debt Service Coverage Ratio (DSCR)
DSCR is a measurement of a business’s ability to repay all its debt obligations using its operating income. This measurement helps borrowers understand how much cash they can afford to repay debt. Also, lenders use it when evaluating a loan application.
The Debt Service Coverage Ratio Formula includes:
DSCR= Net Operating Income/ Total Debt Service
Where:
- The Net Operating Income= Revenue – Certain Operating Expenses
- Total Debt Service= Current Debt Obligations
As a general rule, a DSCR beyond 1.25 is considered vital. On the other hand, a DSCR below one is deemed weak and shows that the business is struggling.
4. Have the Required Documents
Applying for a small business loan can feel overwhelming because of the number of documents required. Typically, the required documentation may vary from one lender to another; hence, it is vital to arm yourself with the necessary documents to reduce loan application hassle and speed up the process.
Generally, you may need the following documents for your loan application:
- Individual tax returns or at least two years
- Corporate tax returns for several years
- Bank statements for at least 12 months
- Some lenders may ask for a business plan
Although most lenders will for documents with at least two years of history, the length may vary from one lender to another.
5. Submit a Formal Loan Application
Once you have ascertained that you can repay the loan and have the necessary documents, the next step is to submit a formal loan application. The application process may vary by lender.
6. The Cost of Credit
After your approval, you now need to familiarize yourself with the cost of credit. It is wise to ask the lender if there are any other fees associated with your loan to avoid surprises and frustrations.
Usually, some of the costs that may come with your loan may include;
- Loan processing and service fees
- Origination fee
- Referral fee
- Late payment fee
- Packaging fee
- Non-sufficient funds fee
- Payment by check fee
- Wire transfer fee
Conclusion
Once you get funding, it is now time to take your business to the next level. Don’t forget to plan carefully on how you intend to use the funds. Also, ensure that you meet the agreed terms and pay your loan as agreed.