A small business loan is a financial arrangement where a lender provides capital to a business owner, who then repays the amount and interest over a specified period. Understanding the steps to apply for a small business loan can help you secure the additional finances you need to help your organization thrive. MoneyGeek explored the process of obtaining a small business loan and some of the pros and cons involved to help you make the best decision for your business.
What Is a Small Business Loan?
Small business loans are financial tools designed to give entrepreneurs and business owners the capital they need to grow, sustain or improve their operations. Unlike personal loans, these are specifically tailored for business expenses and usually offer terms and conditions that align with business needs.
According to the U.S. Small Business Administration, small business loans can range from a few thousand dollars to as much as $5 million, depending on various factors like the lender, the borrower's creditworthiness and the nature of the business.
To take out a small business loan, you'll start by applying through a bank, credit union or online lender. The lender will assess your business's financial health, your credit score and other relevant factors. Interest rates can vary widely, so it's essential to shop around. Once approved, you'll receive the loan funds and will be required to pay them back over a specified period, usually with interest.
4 Steps to Apply for a Small Business Loan
Whether you're a seasoned entrepreneur or a startup founder, understanding how to apply for a small business loan can demystify the process and set you on a clear path to financial growth. Below is a simple four-step process to help you get started.
1. Determine How Much You Need
Determining how much capital you need to borrow is the cornerstone of your small business loan application process. Aligning the loan amount with your business objectives and ensuring you can manage repayment without straining your finances is essential during this first step; do so by finding the right loan type, researching fees and evaluating your business needs.
Find the Right Loan Type
To determine how much money you need to borrow, you must understand the types of small business loans available and which aligns with your needs. For instance, if you're looking to finance a short-term project, a line of credit might be more appropriate than a long-term loan. On the other hand, if you're planning a significant expansion, a term loan could provide the lump sum you need with the benefit of fixed monthly payments.
Merchant cash advances and invoice financing are other options that are particularly useful for businesses with fluctuating cash flow. These loan types are tied to your daily sales or outstanding invoices, providing flexibility but often at a higher cost. Knowing the best loan type for your situation can help you borrow just what you need, avoiding the pitfalls of overborrowing or underborrowing.
Many entrepreneurs overlook the importance of researching fees, focusing solely on the interest rate. However, origination fees, service fees and prepayment penalties can significantly inflate the amount you need to borrow.
For example, if you're applying for a $50,000 loan and the origination fee is 3%, you'll need to account for an additional $1,500. If you don't factor this into your initial calculation, you might find yourself short on funds when it's time to execute your business plan. Some loans also have ongoing maintenance fees or require you to keep a minimum balance, further impacting the total amount you should consider borrowing.
Evaluate Your Business Needs
Start by listing all the associated costs, from tangible expenses like equipment and inventory to less obvious ones like permits and a buffer for unexpected expenses. Subtract any existing funds or projected cash flow you can allocate to the project. This gives you a baseline amount, but don't stop there. Add in the cost of the loan itself, including interest rates and other fees, to get a complete picture of what you'll be responsible for repaying.
Once you have calculated this total loan amount, evaluate it against your current financial situation and future revenue projections. Consider the loan's repayment terms and assess whether the monthly payments are manageable.
2. Find Out if You Qualify
To determine if you qualify for a small business loan, you need to do a deep dive into various factors that lenders scrutinize, such as your credit score, the length of time your business has been operational and your revenue. Understanding these qualifiers prepares you for the application and helps you target lenders more likely to approve your loan.
Find Out Your Business Credit Score
Your business credit score is as a financial report card that lenders scrutinize closely. A high score can be your ticket to a loan with favorable terms, such as lower interest rates and flexible repayment schedules; a low score could limit your options or result in higher interest rates that make the loan less affordable.
Before you even approach a lender, knowing where you stand is vital. You can check your business credit score through specialized agencies like Dun & Bradstreet, Experian Business and Equifax Business. These agencies offer detailed credit reports beyond just a numerical score, providing insights into factors that affect your creditworthiness.
Examine Your Business
Generally, businesses that have been operational for at least two years are seen as more stable and are more likely to qualify for a loan. This longevity suggests a proven track record and lowers the lender's perceived risk. However, keep in mind that lenders don't exclusively consider how long you've been in business; they also take into account how well your business is doing.
Lenders often have minimum revenue requirements, varying widely depending on the loan type and the lender. Meeting or exceeding these revenue benchmarks increases your chances of approval and can result in better loan terms. As such, it's essential to have a clear understanding of your financial statements and be prepared to present them in an honest but favorable light.
Assess Loan Affordability
While it's tempting to focus on the loan amount, the repayment terms of your loan will impact your business months or even years down the line. Lenders typically look at your debt service coverage ratio (DSCR), which is your net operating income divided by your total debt service, to gauge if you can afford the loan. A DSCR of greater than one indicates that you have sufficient income to cover your existing debts and the new loan.
Suppose your business has a net operating income of $120,000 per year, and you're looking at a loan requiring annual payments of $40,000. Your DSCR would be $120,000 divided by $40,000, which equals three. This suggests that you can comfortably afford the loan payments. However, this is a simplified example. In reality, you'll also need to account for variables like seasonal income fluctuations, expense increases or unexpected revenue downturns.
3. Shop Around for Lenders
Shopping around for lenders isn't just about finding someone willing to lend you money; it's about finding the right fit for your business needs and financial situation. Different lenders come with their own sets of requirements, terms and benefits. Knowing your options can help you make an informed decision about the best lender for you. The three most common types of lenders are online lenders, traditional banks and credit unions.
If you need funds quickly or don't meet the stricter criteria of traditional banks, online lenders can be a good fit. These institutions are increasingly popular for their speed and convenience. Applications are typically straightforward, and an approval decision is usually given within 24 hours.
However, this speed and ease come at a cost, often in the form of higher interest rates. Online lenders may also have less stringent requirements regarding credit scores and business history, making them a viable option for newer businesses or those with less-than-perfect credit.
Traditional banks are often the first lenders business owners think of when considering taking out a small business loan. Banks usually offer the most favorable terms, including lower interest rates and longer repayment periods. However, they also have the most stringent requirements. A strong credit score, a business history of at least two years and substantial revenue are often prerequisites to loan approval.
This option is often the most cost-effective way to secure significant funding if you have a well-established business with solid financials and can wait through a potentially prolonged application and approval process.
Credit unions offer a middle ground between online lenders and traditional banks. They often have more favorable terms than online lenders but may be more flexible in their requirements than banks. As nonprofit organizations, credit unions are often more invested in the community and may be willing to consider factors beyond credit scores and revenue.
If you're a credit union member and your company is community-oriented, this could be an excellent option. They're particularly beneficial for businesses seeking smaller loan amounts and those who value more personalized service.
4. Apply for a Small Business Loan
To secure a small business loan, you must submit an application. In this phase, you present a compelling case for why your business deserves funding and provide a comprehensive picture of your business's financial health and growth potential.
Gather Required Documents
The documents you submit with your loan application provide tangible evidence of your business's financial standing and operational history. Typical documents required include:
- Business licenses
- Tax returns for the past two to three years
- Recent bank statements
- Balance sheets
- Income statements
You may also need to provide a business plan, cash flow projections and any existing business contracts or leases. These documents substantiate your claims and give lenders the data they need to assess risk and determine your loan terms.
Submit Your Application
Ensure that all the information in your application is accurate, up-to-date and presented in a clear, organized manner. Any errors or omissions can delay the process or result in a denial. Be prepared for additional queries or requests for further documentation; lenders may want to dive deeper into specific aspects of your business, and your ability to promptly provide additional information can demonstrate your reliability.
Receive Your Loan Funds
Once your application is approved, you'll receive the loan funds as a lump sum or in installments, depending on the loan type and terms. But receiving the funds is just the beginning. It's crucial to keep track of payment due dates and ensure that you meet them. Missing a payment or making a late payment can result in penalties and negatively impact your credit score.
Consider setting up automated payments or calendar reminders to help you stay on top of these obligations. Remember, how you handle this loan can affect your ability to secure financing in the future.
Pros and Cons of Small Business Loans
Securing a small business loan can be a game-changer, offering the financial boost you need to grow and thrive in your business. However, these loans aren't a one-size-fits-all solution and their benefits come with some drawbacks. Understanding the pros and cons of taking out a small business loan can help you make an informed decision that aligns with your business goals and financial situation.
Pros of a Small Business Loan
- Quick access to capital: A small business loan can provide a lump sum of money upfront, allowing you to make significant investments in your business. This money can be invaluable for time-sensitive opportunities, like purchasing discounted inventory or capitalizing on a new market.
- Cash flow management: Loans can add more predictability to your cash flow, especially for businesses with seasonal revenue streams. Having extra capital can help you cover operational costs during slow periods, ensuring business continuity.
- Builds business credit: Repaying a small business loan can improve your business credit score. A higher credit score can open doors to more financing options with better terms in the future.
- Tax benefits: Interest payments on a business loan are generally tax deductible, effectively reducing the cost of borrowing. This can be a significant financial advantage come tax season.
- Retain business ownership: Unlike equity financing, where you give up a share of your business, a loan allows you to retain full ownership. This means you maintain control over business decisions and enjoy the full benefits of any increase in valuation.
Cons of a Small Business Loan
- Interest and fees: While loans provide immediate capital, they come at a cost, often in the form of interest and fees. Over time, these can add up, making the loan more expensive than initially anticipated.
- Collateral risk: Many small business loans require collateral, such as property or equipment. If you default on the loan, you risk losing these valuable assets, which can be devastating for your business.
- Debt burden: Taking on a loan means committing to regular repayments, which can strain your cash flow. If your business hits a rough patch, meeting these obligations can become challenging and lead to financial stress.
- Complex application process: Applying for a small business loan can be time-consuming and requires extensive documentation. This can divert your attention from day-to-day operations, impacting productivity.
Frequently Asked Questions
Navigating the application process for a small business loan can be tricky. Whether you're a first-time applicant or a seasoned business owner looking for additional funding, you likely have questions beyond the basics. MoneyGeek answered some of them below to provide valuable insights.
About Christopher Boston
- U.S. Small Business Administration. "Loans." Accessed September 8, 2023.
The content on this page is accurate as of the posting/last updated date; however, some of the rates mentioned may have changed. We recommend visiting the lender's website for the most up-to-date information available.
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