How Business Loans Work
Loans represent a critical financing tool for both emerging and established entrepreneurs. Thanks to the internet, business owners have more sources of loan capital than ever to choose from. Alternative and online lenders account for an increasing share of the business loan marketplace, which has historically been dominated by government agencies and traditional financial institutions like banks and credit unions.
If you’re new to the world of business loans, you should absolutely take the time to educate yourself on how they work before you pursue one. Loans are critical to the success of many businesses, but if you don’t fully understand the obligations they entail, you could end up putting the financial health of your venture at risk.
This guide examines the basics of how business loans work. It defines key terms, examines the different types of loans, and concludes with tips on how to get one.
Essential Business Loan Terminology
First, familiarize yourself with the common terms and phrases you may encounter as you shop for loans and research your options:
- Annual percentage rate (APR): The APR expresses the sum of interest and fees you will pay on a loan over the course of one year.
- Borrower: A person or business entity that takes out a loan or accumulates debt through another financial instrument. The borrower enters into a legal agreement to repay the balance of the debt according to the lender’s stated terms and conditions.
- Credit report: A comprehensive report, compiled and filed by a specialized reporting bureau, that details a given borrower’s history of using loans and debt instruments. Credit reports generate scores that summarize the borrower’s reliability and creditworthiness, which lenders use to evaluate risk.
- Debt to income ratio: This ratio expresses the proportion of income a person or organization must commit toward their existing debts. It is expressed as a percentage of their total income or revenues.
- Factor rate: The factor rate expresses interest in decimal form. It functions like a multiplier that tells the borrower how much money they will be due to repay after taking out a given loan.
- FICO score: Created by the Fair Isaac Corporation, this metric functions as a credit score. It expresses the level of risk a given borrower presents to a lender.
- Gross income: The total amount of income a person or organization earns before taxes.
- Interest rate: The amount of interest, expressed as a percentage, that accumulates over a specified period of time. For instance, loans can calculate interest daily, weekly, monthly, or annually.
- Origination fee: Lenders sometimes charge borrowers a flat fee for issuing and managing a loan. This is known as an origination fee, and it is usually expressed as a percentage of the loan’s value.
- Personal guarantee: Business loans are usually issued to a separate legal entity from the person borrowing the money. Thus, some loans require the borrower to pledge their personal assets as consideration for a business loan. This is known as a “personal guarantee.”
- Proceeds: The amount of money the borrower receives from a loan.
- Refinancing: Borrowers can reconfigure existing debts by having a different institution take ownership of a previous loan under different terms or repayment schedules.
- Repayment period: The amount of time over which the borrower must repay the proceeds of their loan plus the interest accrued on the debt. It is also known as the loan term.
- Secured loan: A loan that requires the borrower to pledge another asset as collateral.
- Unsecured loan: A loan that does not require the borrower to pledge another asset as collateral.
Types of Business Loans
Traditional and alternative lenders offer a wide range of different loans and financing options. The most common and popular examples include:
A term loan is what most people think of when they hear the word “loan.” With this type of loan, a lender advances a sum of money to a borrower, which the borrower will repay over a specified period of time at an agreed-upon APR or factor rate. Some lenders require businesses to use the loan proceeds for particular purposes, while others place no restrictions on how loan capital can be used.
Term loans can cover longer or shorter periods of time. Shorter terms usually carry higher interest rates.
Business line of credit
A business line of credit is a form of “revolving debt,” which remains available for reuse once the borrower has paid back their previous drawings. They function much like credit cards, but they are usually set up and managed through dedicated accounts administered by the lending institution.
In other words, they come with credit limits and the money the borrower uses accumulates interest at a specific APR.
On the surface, equipment financing works much the same way as a term loan. However, in most cases, the lender protects their capital by requiring the borrower to pledge the equipment being purchased as a type of collateral. If the borrower defaults, the lender takes ownership of the equipment.
Many lenders structure equipment financing so that the length of the loan lines up with the expected lifespan of the asset being purchased.
Companies that issue business-to-business invoices for products or services rendered have the option of using their invoices to secure financing. Invoice financing works like this:
- The borrower signs over the rights to collect an unpaid invoice to the lender
- The lender advances a set percentage of the invoice’s value to the borrower
- When the lender collects payment for the invoice, it releases the rest of the invoice’s value minus any applicable fees and charges
These offer an appealing, lower-risk alternative to term loans.
Merchant cash advance
These loans are uniquely available to retailers and merchants who accept credit and debit card payments. With a merchant cash advance (MCA), the lender advances money to a borrower. In exchange, the borrower gives a small, fixed percentage of their daily credit and debit card transactions to the lender. The daily payments continue until the loan has been paid off with interest.
Small Business Administration (SBA) loan
These loans are backed by the U.S. Small Business Administration (SBA). They reduce risk for lenders, as the SBA agrees to guarantee a set percentage of the loan’s value. For instance, an 80% guarantee means the SBA will repay the lender 80% of the loan if the borrower defaults on their payments.
Qualifying for SBA loans is difficult, and they can take a long time to process, but their terms can be quite advantageous for borrowers.
How to Get a Business Loan
Business finance experts stress the importance of following a structured plan to get the best possible terms on your loan:
- Figure out exactly how much money you need to borrow.
- Explore the different types of loans and identify the one that best meets your needs.
- Review your credit report so you know what your score is. If your report contains inaccuracies, challenge them or have them removed before you apply.
- Shop around for offers and loan options. If possible, use aggregators that facilitate side-by-side comparisons from various lenders.
- Apply for the loan that best matches your needs at the most advantageous possible terms.
When you’re searching for a loan, it’s best not to be in a rush. The more hurried you are, the more vulnerable you become to accepting a loan offer that isn’t in your best interest. It’s also not a good idea to borrow more money than you actually need in your current situation.
Finally, before committing to a lender, do your due diligence. Check the lender’s record with an authoritative agency like the Better Business Bureau (BBB), and consult online reviews to get a sense of real customers’ actual experiences with the lender.