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:

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:

Term loan
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.

Equipment financing
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.

Invoice financing
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:

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:

  1. Figure out exactly how much money you need to borrow.
  2. Explore the different types of loans and identify the one that best meets your needs.
  3. 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.
  4. Shop around for offers and loan options. If possible, use aggregators that facilitate side-by-side comparisons from various lenders.
  5. 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.