The process of getting a small business loan can be daunting, not to mention dealing with different lending institutions and time consuming paperwork. With so many products and funding options out there, you might not be sure where to start from, especially if you have never applied for a business loan before.
We’re here to make the process easier for you. These are 4 things to know before you borrow money:
1. Establish why you need to borrow a business loan
Many small business owners need working capital for a variety of reasons, and the reason you need the money will drive your choice of lender and loan type.
Identifying the purpose of your loan will help you determine the term of the loan that makes the most sense to your needs. For example, it might not make sense to borrow with a three or four-year term to finance new staffing during the holiday season.
Generally speaking, longer-term loans typically have a lower periodic payment, but the total dollar cost of accrued interest, or total cost of the loan, will be higher. In contrast, the shorter the term the higher the periodic payment, but the lower the total dollar cost.
2. Determine whether or not you can service the debt
Once you’ve figured out the reason or purpose of your loan, you need to calculate how much money you really need. You don’t want to take on too much or too little.
Consequently, you should avoid the idea of borrowing as much as you can at any given opportunity as there are costs affiliated with borrowed funds. In other words, you should only borrow what is needed to satisfy your business needs.
Running a simple ROI analysis will help you analyze whether or not your projected cash flow can handle the payments, and if the borrowed funds will add value to the business, it could make sense to borrow a small business loan.
3. Know different types of business loans
We are not living in an age where our borrowing options are limited to banks anymore, so it is important to know which types of loans match with your business profile such as your annual revenue and credit report.
The following is a quick list of some of the most popular loan options that you can consider.
Out of all the options, bank loans are by far the best option as they generally offer low interest rates and longer terms, making them the cheapest option.
Interest rates for bank loans can be anywhere from 4% to 10%. Getting approved from a bank, however, is a very tedious and arduous process, and the qualification standards for bank loans are very high.
Banks generally deal with larger transactions (over $200K), and their application process could take weeks or months. This means that it might not be the best to rely on a bank if you need a smaller amount of loan within a shorter time frame.
SBA loans are sought out by many business owners as they are very affordable, though slightly more expensive than bank loans, and easier to qualify for compared to bank loans.
What makes SBA loans appealing for potential borrowers is that they are long-term, low interest small business loans partially guaranteed by the government, the Small Business Administration (SBA). This partial guarantee essentially reduces the risk for the lender, making it easier for less-qualified business owners to get approved.
A term loan is a lump sum of cash that you pay back over a set term, typically with a fixed interest. Many businesses can qualify for a term loan even if your business profile is not stellar. Term loans are generally divided into two categories: medium-term loans and short-term loans
Medium-term loans are usually offered by online lenders. They offer smaller amounts of funding ranging from $25,000 to $1 million, and the repayment terms are between one to five years.
Interest rates on these loans can range from 6.5% to 20%, making them potentially twice as expensive as SBA loans or bank loans. But, as long as you’ve been in business for a bit, have a good credit profile, and are generating some revenue, it’s not too hard to qualify for medium-term loans. If you are vigilant, you may even get funded in less than a few days, but the whole process can take up to two weeks.
Short-term loans are more readily accessible compared to medium-term loans, except that you pay back with daily or weekly repayments during a shorter period of term (3 – 18 months).
Loan amounts go up to $500,000, and you can get approved and funded for a loan as fast as 24 hours. Unfortunately, short-term loans can get very expensive, with their interest rates ranging from 10% to 90% depending on your business profile and the lender.
Short-term loans have much looser eligibility requirements – borrowers with just six months in business can qualify even with weak credit scores. Business Line of Credit
A business line of credit can give you ongoing access to revolving capital that can act like a cushion on your cash flow. Once approved, you will be given a set pool of funds that you can readily draw on whenever you need the capital. The best part is that you pay interest only on the money that you draw.
Invoice financing allows you to finance account receivable. It provides a solution to cash flow problems for business owners who have late-paying customers, allowing you to change unpaid invoices into working capital.
An invoice factoring company will give you anywhere from 50-90% of your outstanding invoice and hold the remaining in reserve. The invoice factoring company will charge a factor fee on the reserve amount (typically 1% to 1.5%) each week it takes your customer to pay.
When a customer pays the invoice, you receive the remaining 10-50% reserve amount, minus the fees.
Equipment financing is a great way for business owners to fund up to 100% of the value of your new or used equipment which includes, but is not limited to, machinery, tools, and vehicles. Because the equipment itself can serve as collateral, it can be an excellent option for business owners without great credit scores.
Merchant Cash Advances
Merchant cash advances (MCA) are considered to be the easiest and fastest way for business owners to get some funds, but they are also the most expensive option out there. MCA is usually suitable for business owners who need immediate access to capital or address other unexpected business expenses quickly.
4. Determine what business loans you might qualify for
The next step to take is to find out the most logical loan options based on your eligibility. Different types of loans and their related lenders will have eligibility requirements that vary from one another. However, most lenders will look at the following three general qualifications to determine your eligibility.
Firstly, lenders will determine your eligibility based on your annual revenue.
Your annual revenue will affect the loan amount, term, and interest rate based on how much money you are bringing yearly. Evidently, a lender will never approve a loan that exceeds your average annual revenue. With most lenders, you will be approved for a loan that is a small portion of your annual revenue
The amount of average annual revenue you will require for a business loan will depend on the amount and the type of loan you are looking for. Online lenders that offer smaller amounts of loan will require much less as to bank loans or SBA loans, which require you to have higher annual revenue.
Another important thing that lenders look at is your credit profile.
As most business owners are aware, the higher your credit scores, the better chances of acquiring a business loan. For lenders, having a strong personal and business credit score indicates that you will be more likely to make on-time payments with no hiccups.
If your personal credit score is sitting above 680, you will have an easier time shopping for a business loan as there will be many more options for you. You will also get better rates and terms. This can give you better chances at landing on higher-end loan products such as bank loans or SBA loans.
A credit score of 650 and below may not get you the most affordable types of business loans. That does not mean, however, that you have no available options. If the overall health of your business is in good standing, you may qualify for products like invoice financing, short-term loans, equipment financing, and lines of credit even without perfect credit scores.
Time in Business
If your business has been operating for at least 2 years, you will have a much easier time to get your hands on traditional bank loans, SBA loans, or long-term loans.
You may have already guessed as to why: the more years under your belt, the more confident a lender will be with your business. It’s all about risk assessment for lenders, and seeing that you have been in business for at least 2 years is reassuring for lenders.
A business of less than 2 years will have a bit more limited options with business line of credit, short-term loans, invoice and equipment financing.
If you have been around for less than 6 months, it’s going to be much harder to get any of the aforementioned products. The only products you will qualify for will be merchant cash advances and business credit cards.