8 Things to Know before Applying for a Business Loan
Business loans are an essential source of commercial financing. Pre-COVID estimates suggest that about 40% of U.S. business owners apply for a loan each year, and those figures are likely to rise sharply in the years ahead as enterprises collectively dig their way out from under the pandemic.
If you’re looking into a loan as a way to meet your business’s financing needs, it’s essential that you properly prepare. To that end, here are eight essential things to know before you start filling out loan applications.
1. The Purpose of the Loan
One of the first questions you will be asked is, “What is the intended purpose of the loan?” You need to provide a specific, practical answer.
In processing your application, lenders pay close attention to the way you think about money. Offering a haphazard or vague answer will likely dampen your chances of gaining approval, since it signals that you haven’t thought things through.
Some of the most common reasons business owners borrow money include:
- Financing the purchase of necessary equipment, facilities, or essential assets
- Funding your company’s growth and expansion plans
- Solving short-term cash flow shortfalls
Your answer doesn’t have to be complicated. It just needs to make sense to the lender.
2. How Much Money You Need
As with the purpose of your loan, lenders are looking for reasoned, specific answers to this essential query. When asked how much money they need, some would-be borrowers laughingly respond, “As much as I can get!” This will raise the loan officer’s eyebrows, as they will once again be looking for evidence that you are realistic and responsible with money.
In some cases, it will be easy to figure out how much money you need. For instance, if you’re looking to finance the purchase of a piece of precision machinery, you simply need to borrow the difference between its price and the amount you can contribute yourself.
Other situations require a little more planning. Covering a cash flow shortage is a common example, as these situations are more complex and demand more calculations. Sit down and do the math before you fill out any loan paperwork. This will also help you avoid overborrowing, which can create a potentially dangerous financial burden.
3. How Much You Can Afford to Carry
Another important bit of math involves figuring out how much you can safely afford to repay. Online loan calculators are helpful tools at this stage, allowing you to generate accurate repayment estimates by plugging in the loan amount, interest rate, and repayment term.
Here are a few tips to guide your computations:
- Use your recent financial statements and future cash flow projections to paint a picture of your business’s current and near-future financial situation
- You can reduce your repayment amounts by extending the loan term if this is an option
- Extending the loan term will also increase the lifetime cost of the loan
Lenders want to make sure borrowers can manage their payments, as this vastly reduces the chances that the borrower will default. Thus, many lenders are flexible when it comes to setting up repayment plans.
4. Your Credit Score
Some lenders impose very strict limits on credit scores, offering loans only to borrowers at or above a specific threshold. Others maintain looser standards, accepting borrowers from all financial backgrounds.
In either case, your credit score will profoundly impact the terms you are offered. Borrowers with higher credit scores will qualify for the lender’s lowest interest rates. This is because they present less risk.
Each of the three major credit reporting bureaus (Equifax, Experian, and TransUnion) are obligated by law to provide you with one free copy of your credit report per year. Request yours before you apply for a loan, review it in detail, and challenge any inaccuracies you find.
Another thing to note: some lenders do a “soft pull” of your credit score, looking only at surface details of your borrowing history. Others require a detailed “hard pull.” You should know that soft pulls will not affect your score, but a hard pull will temporarily lower it. If you’re not sure what type of credit inquiry a given lender makes, be sure to clarify in advance.
5. Your Ability to Offer Collateral
In financial terminology, collateral is an asset a borrower pledges as consideration for receiving a loan. The borrower retains ownership of the asset if the loan is in good standing, but if they fail to honor their repayment obligations, the lender will claim the collateral.
Loans that do not require collateral are known as “unsecured loans,” while those that do are called “secured loans.” Some lenders only offer unsecured loans, but if secured loans are available and you are confident in your ability to manage your repayment obligations, they are worth considering. Secured loans carry lower interest rates, since the collateral reduces the lender’s risk.
To this end, take stock of your assets before applying for a loan to see what kind of collateral you can offer. Assess the current value of those assets, then compare various loan terms to see how your unsecured and secured options stack up.
6. A Complete Understanding of Total Loan Costs
Repaying your loan principal plus interest may not be the only costs associated with your loan. Some lenders charge additional fees such as “origination fees,” which are usually computed as a small percentage of the loan amount. Others use alternatives to annual percentage rates (APRs), which are the standard way to calculate interest. Factor rates are a common example.
In a highly competitive marketplace, some lenders draw customers in by offering fantastically low APRs, only to tack on hefty origination fees and other charges that drive costs back up. You should develop a thorough understanding of the various loan and fee structures on the lending market. This will help you avoid an undesirable surprise once the loan paperwork is processed.
7. The Types of Loans Available to You
Term loans provide the borrower with a lump sum, which must be repaid with interest over a specified period of time. This remains one of the most common loan types, but lenders offer many others.
- Commercial mortgages for property purchases
- Specialized equipment financing loans that fund equipment purchases
- Invoice financing (also known as accounts receivable financing), which allows you to “sell” unpaid invoices to a lender in exchange for cash up front
- Merchant cash advances, which enable business owners to borrow against the daily debit and credit card payments they receive
Each of these loans types offers specific situational advantages, but you also need to weigh those advantages against potential drawbacks. Educate yourself about your loan options and run the numbers multiple times to see if a particular type of loan delivers a better deal.
8. You Have Many Options
The days of banks and governments being the sole sources of business financing are over. Thanks to the explosion of the fintech industry, alternative and online lenders are making increased market share gains. Many of these companies also offer superior value and better terms, thanks to their lower overhead and innovative use of risk evaluation technologies.
In researching your options for both loan types and lenders, cast a wide net. Comparison sites and loan aggregators are also excellent resources, since they create a situation in which lenders must compete head-to-head for your business.
Before you commit to a specific lender, do your due diligence. Look into their background, consult professional and user-generated reviews, and stick to reputable companies that prioritize transparency.