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October 15th, 2019

HOW-BUSINESS-LOANS-WORK

How do Business Loans Work?

A business loan is a form of borrowing designed to support business purposes. A car loan allows you to buy a car, a mortgage enables you to buy a house, and a business loan could help your business grow and succeed.

When you decide to apply for a business loan, you should have a clear purpose for those funds. Whether it is to purchase new inventory, fund expansion, or remodel a store, the best business loan will return more value to your business than its cost.

10 Most Common Types of Business Loans

While you may start your borrowing journey merely knowing that you need access to capital, you will need to learn the differences between types of business loans to select the best for your business. Each loan product has different terms and rates, and once you have familiarized yourself with them, it will likely be easy for you to identify your best option.

Below is a list of the most common business loan types, as well as their typical rates, terms, and qualification requirements. While meant to provide an overview of what a small business owner can expect to find in the lending marketplace, interest rates and terms change often. As well, lenders have their own documentation requirements when you complete an application.

1. Bad Credit Business Loans

Type of Loan:Bad Credit Business Loan
Common Terms:2 – 18 months
Repayment Schedule:Daily, Weekly, Bi-Weekly, Monthly
Interest Rates:12% – 45%
Required Credit Score:500 or higher
Revenue Requirements:$8,000/month
Time in Business:Minimum 2 months
Collateral Requirements:None.
Application Requirements:Driver’s License
Proof of Income (Bank Statements, Paystubs)
Where/How to Apply:Online.

One of the easiest loans to qualify for, bad credit business loans make it possible for everyone to have access to capital. Alternative lenders design their products for those whose business circumstances and credit disqualify them for a bank loan.

Bad credit business loans have a fast approval process, sometimes as little as 24 hours, and the loan’s funds could be disbursed within a few days. They have quick and easy online application processes which do not require much documentation. Unless you are applying for a large loan a lender giving you a bad credit business loan will not request tax returns or bank statements

An underwriter at an alternative lender primarily bases their lending decision on monthly and annual revenues. They also consider how long you have been in business, which can be as little as two months. Small business owners with credit scores above 500 and a business that generates $8,000 of monthly revenues will find it easy to obtain a bad credit business loan.

Alternative lenders have more flexibility in the amounts that they will lend, unlike banks who typically do not want to give smaller value loans. They lend amounts between $5,000 to $1 million.

Shorter approval times do not give lenders the luxury of verifying your credit-worthiness, which means that an alternative lender is taking on more risk with your loan. They charge higher interest rates to cover their risk. The interest rate on a bad credit business loan will range from 12% to 45%. It could still be lower than other funding options such as invoice factoring or a merchant cash advance.

Best for Small Business Owners Who;

  • Have poor credit
  • Need cash quickly
  • Do not want the hassle of a bank application
  • Have only been in operation a short time

2. Unsecured Business Loans

Type of Loan:Unsecured Business Loans
Common Terms:2 – 36 months
Repayment Schedule:5x a month to Monthly
Interest Rates:7% – 36%
Required Credit Score:500 or higher
Revenue Requirements:$25,000 – 50,000 a year or $10,000 minimum monthly revenues
Time in Business:1 year
Collateral Requirements:None.
Application Requirements:Driver’s License

Business License

Proof of Revenue

Credit Check

Where/How to Apply:Online or at a bank.

Some business loan lenders insist that you pledge collateral for your loan. Collateral is tangible assets which could be seized if you defaulted. It could be a building, a piece of machinery, personal investment accounts, or anything of value. When you pledge collateral to secure a loan, the lender now has a right to that asset until you have repaid the loan.

Equipment financing loans, an example of a loan that is secured by collateral, meaning that you could lose an important piece of machinery and go out of business. Because of the risks of pledging collateral and how it could impact their ability to continue operating, many small business owners prefer to take out unsecured business loans.

An unsecured loan is one that is extended based on your personal guarantee or credit score. The lender does not have recourse to any physical assets, and thus has higher risk. Because they base a loan’s interest rate on their perceived risk and profit margin, you will pay more for an unsecured loan.

The difference in what you would pay for interest on a loan with pledged collateral and interest on a loan without collateral should be worthwhile to you. Does it matter more to you to retain control of your asset than to pay 2-3% more in interest on a loan? Then talk to a lender about an unsecured loan.

Best for Small Business Owners Who;

  • Do not have collateral to pledge
  • Do not want to risk their collateral

3. Business Line of Credit

Type of Loan:Business Line of Credit
Common Terms:6 – 12 months
Repayment Schedue:Monthly payments
Interest Rates:5% – 25%
Required Credit Score:650 or higher
Revenue Requirements:$10,000 monthly revenues
Time in Business:6 months minimum
Collateral Requirements:None.
Application Requirements:Driver’s License
Business Licenses
Bank Statements
Proof of Ownership
Property Lease Agreement
Voided Check
Where/How to Apply:Online or at a bank.

Business lines of credits, or LOC’s, are one of the best small business loans for businesses which struggle with cash flow. Like a credit card, once you have been approved for it, the line remains open. You can draw on that capital when needed.

Business lines of credit have upper limits, and typically stay open for one or more years. The balance owed on a line of credit freezes at year one or year five and converts to a term loan.

Your lender only requires payment, and you will only pay interest if you draw on the line of credit. However, some lenders charge annual fees to have the line open if you are not using it regularly. Every time you take out a withdrawal, you could be charged a draw fee.

Both banks and alternative lenders will open lines of credit, though a bank could require the same level of documentation in your application as when you apply for a loan.  Because the underwriter does more due diligence than with other types of business loans, you will pay a lower interest rate than a credit card.

Approval times and limits vary, but they can take as little as a few days if you have an existing relationship with the bank. While both lenders will pull your credit score and banking history, negative information may just lead to a higher interest rate or lower draw limit rather than being turned down.

Best for Small Business Owners Who;

  • Want access to cash without reapplying for a loan
  • Need to manage cashflow fluctuations
  • Want to draw on and repay a line of credit frequently
  • Have a decent to great credit score

4. Merchant Cash Advance

Type of Loan:Merchant Cash Advance
Common Terms:12 – 24 months
Repayment Schedule:Daily credit card transactions
Interest Rates:24% – 49%
Required Credit Score:500 or higher
Revenue Requirements:Depends on amount advanced
40% – 50% of monthly revenue from credit/debit card sales
Time in Business:3 months
Collateral Requirements:Upcoming credit card sales
Application Requirements:Proof of credit card sales
Bank statements
Driver’s license
Business license
Where/How to Apply:Online.

A merchant cash advance or MCA will be the best option for businesses whose customers pay primarily by credit card. If your sales fluctuate, but you know you can repay the loan quickly, then an MCA could help you manage a temporary cashflow issue. When you take out an MCA, you are borrowing against your future sales. The lender takes their repayment amount from your future credit card sales.

To determine your loan amount, the underwriter will analyze credit card or bank statements and calculate average cash inflow over the past few months. This tells them if you have money coming into the business and how often, and if it’s sufficient qualifying for an MCA can be easy and quick.

The loan will be repaid every time you swipe a credit card. The lender deducts a percentage from each sale. This percentage includes their principal and profit, but if it takes a long time for you to repay the MCA, the interest rate could rise.

Interest rates on an MCA can start at 15% and get as high as the triple digits. A bad credit business loan, business credit card, or short-term business loan could all have a much lower cost of capital if you cannot repay the MCA over the next few weeks.

Best for Small Business Owners Who;

  • Receive the bulk of their sales as credit card payments
  • Do not want to worry about making monthly payments
  • Need fast access to funds

5. Short Term Business Loan

Type of Loan:Short Term Loan
Common Terms:Less than Two Years
Repayment Schedule:Daily, bi-weekly, weekly, or monthly
Interest Rates:9% – 45%
Required Credit Score:650 or higher
Revenue Requirements:$10,000 minimum monthly revenues
Time in Business:1 year or more.
Collateral Requirements:Personal guarantee, pledged collateral, or none.
Application Requirements:Driver’s License
Business Licenses
Bank Statements
Proof of Ownership
Property Lease Agreement
Voided Check
Where/How to Apply:Online or at a traditional bank.

Short term business loans have a two-year or less repayment period. Your payment stay the same if it’s a fixed-rate loan, making budgeting easier than an MCA or business line of credit. If you do not need a large sum of capital, but just want to borrow a few thousand dollars a short-term business loan could be an excellent choice. Short-term lenders do not lend large sums because of the risk of non-payment.

A condensed repayment period leads to a higher monthly payment. For example, a $12,000 loan repaid over six years has monthly payments of $88, but repaid over three years the payment jumps to $167. Before taking out a short-term business loan, check your budget to determine if you can afford the higher payments.

While working with the lender on your loan application, they will establish a repayment plan of monthly, bi-weekly, weekly, or even daily payments depending on your business’ cashflow pattern. Generally, payments will be automatically deducted from your bank account. 

Best for Small Business Owners Who;

  • Only need a loan for a short time
  • Need to borrow a specific amount
  • Prefer a fixed payment

6. Business Loans for Women

Type of Loan:Business Loans for Women
Common Terms:2 – 36 months
Repayment Schedule:2 to 7 monthly payments
Interest Rates:12% – 45%
Required Credit Score:500 or higher
Revenue Requirements:$8,000 minimum monthly revenues
Time in Business:Minimum 2 months
Collateral Requirements:None.
Application Requirements:Driver’s License
Business Licenses
Bank Statements
Proof of Ownership
Property Lease Agreement
Voided Check
Where/How to Apply:Online or by phone.

Historically it has been harder for minorities such as women to access capital. The lending gap is a known issue, one which alternative lenders play a role in solving. Women still receive approval for business loans at a rate of 33% less than men.

Many organizations, non-profits, and government agencies make funding available to help women access the capital needed to succeed in business. Shield Funding offers business loans specifically designed for female borrowers.

Best for Small Business Owners Who;

  • Are female
  • Dislike borrowing in a male-dominated environment

7. Invoice Factoring

Type of Loan:Invoice Factoring
Common Terms:Up to 12 weeks
Repayment Schedule:Repaid as invoices are paid
Factor Rates:.69% – 3%
Required Credit Score:None.
Revenue Requirements:None.
Time in Business:None.
Collateral Requirements:Past due receivables
Application Requirements:Proof of past due invoices owed
Credit score checks on customers
Driver’s license
Business licenses
Where/How to Apply:Online, invoice financing lender.

Invoice financing helps small business owners who are struggling to get by due to a large number of customers who are not paying on time. Invoice financing lenders advance money on the basis of your past due receivables. Your accounts receivable are either pledged as collateral on a loan or sold outright at a discount on their face value.

An invoice financing lender will not give you 100% of the invoice’s amount. Do not expect them to lend a dollar for every dollar you are owed. They keep a reserve from advanced funds to protect them from customers who never pay, and they could only advance you 80-85% of the total invoices.

Invoice factoring lenders buy your outstanding invoices at a discount and collect on them from your customers. You have no further interaction with the customer regarding the amount owed. This can negatively impact your relationship with customers if the company is rude when collecting, plus customers could worry that you are going out of business.

If it is your first time working with the invoice factoring lender they might want to pull your customer’s credit scores and other financial information. This will delay the approval process, so invoice factoring might not be the best choice if you need money immediately.

Best for Small Business Owners Who;

  • Are owed significant past-due sums
  • Have customers with good credit
  • Do not need to collect 100% of the balances owed
  • Are not great at collecting on their accounts receivable

8. Equipment Financing

Type of Loan:Equipment Financing
Common Terms:Months to 10 years
Repayment Schedule:Monthly fixed payments
Interest Rates:4 – 12.75%
Required Credit Score:600 or higher
Revenue Requirements:$250,000 a year in revenues
Time in Business:2 years
Collateral Requirements:Equipment
Application Requirements:Equipment Appraisal or Valuation
Driver’s license
Business license
Proof of Ownership
Proof of funds for downpayment
Where/How to Apply:Traditional bank or equipment financing lender

Equipment financing loans finance the purchase of large pieces of equipment, with the equipment then serving as collateral for your loan.  While equipment financing lenders will check your credit, it is less important because this is not an unsecured loan.

If you are buying a new forklift with the loan, the bank would be able to seize the forklift if you defaulted or missed payments. Small business owners with poorer credit could be asked to put a down payment on the equipment, but poor credit will not automatically disqualify you from being approved.

Some equipment lenders will finance up to 125% of the equipment’s value to cover costs associated with the purchase such as shipping and delivery. Banks rarely lend if you have less than two years of business history and will have minimum annual revenue requirements.

Lenders will ask you to supply them with information about the equipment’s age, condition, and value. You cannot apply for the loan until you have an actual piece of equipment you plan on buying. They could accept your appraisal or the seller’s appraisal to establish its value. Or, they might send out their appraiser to confirm its value if it’s a particularly expensive item.

The terms on an equipment financing loan, typically 2-3 years, usually align with the equipment’s useful life or depreciation schedule. Many lenders grant a 90-day grace period before you have to make your first payment. This saves you money and means that you can start generating revenues with that new equipment to support payments on it.

Best for Small Business Owners Who;

  • Have decent credit
  • Need to purchase equipment
  • Do not mind pledging said equipment as collateral

9. Bank Business Loans

Type of Loan:Bank Business Loans
Common Terms:1 to 3 years.
Repayment Schedule:Fixed monthly payments
Interest Rates:4% – 6%
Required Credit Score:700 or higher
Revenue Requirements:$250,000 or higher annual revenues
Time in Business:2 or more years.
Collateral Requirements:Depends on loan.
Application Requirements:Driver’s License
Business License
Social Security Card
Tax ID number
Tax Returns
Bank Statements
Credit Card Statements
Audited Financial Statements
Personal guarantee and personal taxes
Where/How to Apply:Online or at a bank branch

Banks maximize their profits and minimize their risk by lending large sums to highly qualified borrowers. They rarely lend in amounts under a hundred thousand because the costs to generate a small loan are the same as generating a large loan, but the large loan produces more profit. This means that it can be difficult for small business owners to qualify for a loan at a bank.

The minimum qualifications for a bank are typically a credit score above 620, a business history longer than two years, strong monthly and annual cash flows, and a business plan or definite purpose for the loan. That is just the beginning; the loan’s underwriter could request even more documentation. Prepare to spend days pulling together several years of tax returns and bank statements, a five-year business plan, and audited financial statements. They could also ask for the resumes of top executives, personal guarantees, or collateral.

The underwriting and approval process at a bank or a traditional lender can take months.

Best for Small Business Owners Who;

  • Can wait several months for approval
  • Have the time to complete lengthy applications
  • Can provide significant documentation
  • Have excellent credit

10. SBA loans

Type of Loan:SBA Loan
Common Terms:Up to 7 years
Repayment Schedule:Fixed monthly payments
Interest Rates:3% – 6%
Required Credit Score:680 or higher
Revenue Requirements:Depends upon Amount Borrowed
Time in Business:Two years or more
Collateral Requirements:Personal guarantee
Application Requirements:Driver’s License
Business License
Social Security Card
Tax ID number
Tax Returns
Bank Statements
Audited Financial Statements
Personal guarantee and personal taxes
Where/How to Apply:At an approved SBA lender

The Small Business Administration or SBA ensures loans made to small business. While funded by the government, you do not take out a loan from the government. Instead, the SBA works with traditional lenders who have been approved to lend through their program.

SBA loans offer small business owners excellent interest rates and terms. Those with slightly lower credit scores might still be approved due to the government guarantee. You must meet stringent criteria for qualification, however. Thus, SBA loans are often not an option for many small business owners.

When applying for an SBA loan, you have to complete an application for both the bank and the SBA. You could be required to supply them with business and personal tax returns, financial statements, a business plan, one year’s projected cash flow, and more. Like a traditional bank loan, it can take several months to apply and receive approval for an SBA loan.

Best for Small Business Owners Who;

  • Have good to excellent credit
  • Have been in business for more than two years
  • Need a fixed-rate, longer-term loan
  • Do not need capital quickly

If you have any more questions about how business loans work, or which loan will meet your business goals, reach out and talk to Shield Funding today.

Dena Landon

Dena is a senior writer at Shield Funding, reporting on various topics related to small business loans and business financing. Previously her work has appeared on The Washington Post, Narrative.ly, Salon, and others. Her first novel was published by Dutton Children’s Publishing in 2005. She has a Master's in Business Administration from Capella University and has worked in the finance field for over fifteen years.
Dena Landon