How to Decide Which Type of Business Loan Is Right for You
There are many types of business loans. Here’s how to choose the right one for you.
- There are many different types of business loans, including working capital loans, SBA loans, and loans from friends and family.
- Each loan type comes with its own set of terms and conditions.
- To determine which loan is right for you, carefully consider what your business needs the loan for, what repayment terms you can handle and how much money you need.
Finding the right sources of funding for your business can be difficult. There are many types of funding available – investors, grants, loans, etc. – and each has its own application process and set of rules.
One of the most common options for small business funding is a business loan. Small business funding sounds like it should be easy enough to obtain, but borrowing money is not as straightforward as it seems.
A 2017 study found that 27% of small businesses have difficulty gaining adequate financing. As a business owner, you need to know your options so that you can tailor your application to the type of loan you need and lay out exactly how you plan to use the funds.
Friends and family loan
We’re all familiar with this option, but there are specifics as to when and how to do it that surprise you. First, it’s always a good business practice to put the loan in writing, and to state a specific interest rate and repayment plan. Otherwise, you open the door to unfortunate misunderstandings that can chill your relationship. Also, you should have documentation of the loan’s terms in case the IRS decides to audit your business.
Borrowing from loved ones carries risk. We’ve outlined the benefits and drawbacks of borrowing money for your company from your parents, and a lot of these tips hold true for other family members and close friends who may lend to you. The reality is that many people may not have extra money to part with or, if they do, aren’t comfortable parting with such a large sum for something they have no control over. Be sure to “overcommunicate” the value you bring to your customers, and indicate if and how your friends and family will be able to participate in your business.
You should provide a written promissory note that states how much money they can expect you to pay back and at what interest rate. With this note, you’ll also want to specify a repayment schedule in writing.
Money borrowed from friends and family can come with the best low-interest repayment plan you’ll ever get. This is one of the best reasons to borrow money from friends and family instead of banks and commercial lenders. You may also expand your sales force when you borrow money from those you know: When they’re financially invested (in addition to being personally invested as someone who loves you), they may take it upon themselves to help you succeed and reach your business goals.
How to apply
To show you’re serious about requesting funding from relatives, you may want to approach the subject formally, armed with your business plan, projections, outlines of how you’ll use the money, specifications on your friends and family’s involvement in your business financing, and suggested loan terms and repayment terms.
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Business line of credit
A business line of credit is a flexible business loan that allows you to only pay interest on the portion of money that you borrow. It works similarly to a credit card in that you may draw and repay funds as you need, so long as you do not exceed your credit limit. This is a great option for businesses looking for an easy way to manage their cash flow, purchase inventory or pay a surprise expense.
A business line of credit works like a credit card, allowing you to take out and repay money on your own terms as long as you stay within your credit limit and make payments on time. Most lenders will allow you to pay off your balance early to keep your interest costs down.
Line of credit limits tend to be lower than business term loan amounts – generally from $1,000 to $250,000 – and are unsecured, so you typically do not need to put up collateral except in the case of a larger line of credit.
Business lines of credit are a flexible option that allow you to manage your business’s cash flow as you see fit, and you can reuse and repay your credit as often as you need.
How to apply
Similarly to business term loans, you can get a business line of credit from either a traditional bank or online lender. Banks will require your business to have strong revenue and one to three years of positive history to qualify, as well as the following documentation:
- Tax returns (business and personal)
- Bank account information
- Business financial statements
Online lenders generally have fewer restrictions and qualifications than banks, but they tend to charge higher interest rates and have lower credit limits.
To qualify for a business line of credit from an online lender, you’ll need to have been in business for at least six months, make $25,000 or more in annual revenue, and have a credit score of 500 or higher.
Working capital loan
Working capital loans are short-term business loans designed to bring extra cash into the business to use for growth and expansion, and for day-to-day expenses such as advertising, payroll or inventory purchases. You can also use working capital loans to cover emergency costs or pay down debt.
Like personal loans, working capital loans require you – as the business owner – to have a sparkling personal credit history. Applications for this type of funding require a significant amount of paperwork, and processing can take weeks or even a few months.
Working capital loans are effective because they finance the everyday operation of your business and usually have low interest rates. You may be able to secure a rate between 3% and 7% if you have a great credit score.
How to apply
Working capital loans are typically available through large, national banks as well as regional or statewide banks. You might also look into working capital loans available at your local credit union or through a third-party direct lender. For the best chances of securing a working capital loan, approach the bank that you already do business with first. Not only will it have access to a lot of your financial information, but it will be able to review your existing banking and credit habits to assess risk.
Business term loan
A business term loan is a lump sum of capital that you pay back in regular payments at a fixed interest rate for a set period of time – which is where the “term” part comes in. The term is generally one to five years.
The purpose of a business term loan is to allow you to finance a large purchase for your business, such as equipment or new facilities. There are few restrictions to a business term loan, and most businesses that have good credit and generate revenue will qualify.
With a business term loan, you get a predetermined amount of money and a fixed interest rate to be repaid in a set number of years. The loan amount will depend on your business and its needs, but it’s generally within the range of $25,000 to $500,000, with interest rates from 7% to 30%.
A business term loan generally has few restrictions and can help you build your business by introducing new capital for purposes like a new office or equipment. You will also have all of the information and terms regarding your loan from the get-go, but it’s still important to carefully read the contract so nothing will be a surprise down the line as you start making payments.
Business term loans are suitable for a wide range of businesses, and they generally offer lower monthly payments and longer payment terms than short-term loans.
How to apply
You have a couple of options when applying for a business term loan. They are traditionally available through banks, though that can be a long and arduous application process. Several banks offer expedited online applications, though. These are some of the documents you’ll need:
- Driver’s license
- Voided business check
- Bank statements
- Balance sheet
- Credit score
- Tax returns (personal and business)
- Profit and loss statements
Small Business Administration (SBA) loan
SBA loans are government-backed loans that are available to small businesses from private-sector lenders. These are secured loans, meaning you must pledge your company or personal assets as collateral. There are three different SBA loan programs:
- The 7(a) Loan Program is the SBA’s main program for providing assistance to small businesses. The terms and conditions vary by loan, and maximum loan amounts range from $350,000 to $5 million.
- The Microloan Program provides the smallest loan amounts available from the SBA, ranging from $10,000 to $50,000. Microloans are ideal for small startups, borrowers with limited collateral or companies that just need a small financial boost.
- The CDC/504 Loan Program offers loans to small businesses with long-term fixed-rate financing for the purposes of expansion or modernization – such as large equipment or real estate purchases. These are typically larger loans, “generally capped at $5 million.” Terms are 10, 20 or 25 years, depending on the purpose of the loan.
There are multiple conditions under which SBA loans cannot be issued, including if a business is operating as a nonprofit or is not based in the United States. SBA loans cannot be used to repay delinquent state or federal withholding taxes.
Terms vary by the size of the loan, the planned use of the money and your needs as a small business borrower. The maximum term allowed for a microloan is six years. Interest rates are usually between 8% and 13%.
Each SBA loan has its own unique benefits. For instance, a 7(a) loan is extremely versatile and can be used to purchase land or buildings, cover new construction, finance equipment or other supplies, or acquire an existing business.
Microloans may be available to businesses that otherwise wouldn’t qualify for a loan. They can also be used in multiple ways – as working capital; to purchase inventory, supplies, furniture and fixtures; or to buy machinery and equipment.
The 504 Loan Program, which borrowers typically use to buy commercial real estate or heavy equipment, offers both short-term and long-term benefits, including 90% financing, longer loan amortizations, fixed interest rates and overall savings.
How to apply
Each program has specific eligibility criteria and an application process. Visit the SBA website for information on how to apply for an SBA loan and for checklists to ensure you have everything you need for a successful loan application.
Accounts receivable factoring
Accounts receivable factoring is also known as receivable financing. This type of business loan is used to convert sales on credit terms for immediate cash flow. For example, if you provide outsourced marketing services to large enterprise clients, you might sell your existing, uncollected invoices (which you are waiting on payment for) to a third party for an advance payment. This third party, called the factor, provides you with the full or partial amount and then collects on the sale from your customer. This type of financing is generally used to buy your small business some time while you look for more long-term, sustainable sources of financing.
This receivable credit line can be costly, so you should exhaust all other efforts of financing before turning to it. Once you factor in a discount fee, interest rates of 10% to 25%, and other charges, you could end up paying much more over time than you would with other financing options. Also, your financing is determined by the financial strength of your customer, not you as a seller of goods or services. Most invoices over 90 days old will not get financed, and invoices that are paid out quicker will afford you more beneficial terms.
One of the greatest advantages of this type of business loan is that it allows you to cash in immediately on your future receivables; you won’t have the majority of your capital tied up in inventory or unpaid invoices. It may also be beneficial to outsource your accounts receivable management to another company, freeing up your focus for productive work on your business. This funding is also faster than many options, as you don’t have to provide a business plan or tax statements.
How to apply
Most companies that offer accounts receivable financing are commercial lenders, not banks. To apply for accounts receivable financing, you’ll have to fill out an application and hand over your articles of incorporation, your company’s most recent accounts receivable and payable reports, a master customer list, and an example of your typical invoice.
Merchant cash advance
A merchant cash advance isn’t technically a loan, but rather a cash advance based on the credit card sales deposited into your merchant account.
Merchant cash advances are quick, often depositing funds 24 hours after approval. Historically, merchant cash advances have been used by businesses that primarily subsist on credit and debit card sales, such as restaurants and retailers, but they have become available to other businesses that do not rely on card payments.
With a merchant cash advance, you receive an upfront sum of cash in exchange for a portion of your future credit and debit card sales or by remitting fixed daily or weekly debits directly from your bank account.
Merchant loan advances provide you with fast money but carry high annual percentage rates that consist of the total cost of the loan plus all fees. They can run your business into debt quickly if you are not careful.
Your fee amount is determined by your ability to repay the merchant cash advance. The provider will determine a factor rate of 1.2 to 1.5 based on a risk assessment. The higher the factor rate, the higher your fees. Your total repayment amount is the factor rate times the cash advance.
The main draw of merchant cash advances is that they are fast; you could have cash in hand less than a week after submission with little to no paperwork. Merchant cash advances are also unsecured, which means you do not have to put up collateral in case you cannot repay, and repayments will adjust to how well your business is doing.
How to apply
Applying for a merchant cash advance is simple. Start by looking at online business lenders and filling out their online applications. Expect to provide three months’ worth of financial statements.