Small business loans are a path for qualified entrepreneurs to get much-needed capital for growth. Before you apply for one, though, it's important that you understand your options and determine which type of loan is right for your business and financial circumstances.
Here's what you need to know about the different types of small business loans, how to choose one, and how to improve your chances of approval.
Types of small business loans
Small business loans can vary greatly depending on the scope of your business and its needs. Here are some common types of small business loans you can expect to find.
Traditional or term loans
A term loan, which is also referred to as a traditional loan, is financing borrowed from a bank that has to be repaid over a set period of time. It could be either for a short or long period, ranging from a few months to several years. The size of the loan you may receive depends on several factors, including the lender's requirements and the loan amount requested, as well as your business's industry, size, and history.
SBA loans
The U.S. Small Business Administration (SBA) funds several loans that are guaranteed by the federal government. The most common type of SBA loan is the SBA 7(a) loan.
The 7(a) loan has a maximum limit of $5 million and is generally used to purchase real estate, as well as for working capital and debt refinancing. The SBA 504 loan also has a maximum limit of $5 million and must be used for major fixed assets, such as existing land or building new facilities. SBA microloans are extended up to $5,000, with the intention of helping small businesses grow and invest in their working capital, inventory, and equipment.
[Read more: How to Apply for a Small Business Loan for Your Startup]
Equipment financing loans
An equipment financing loan allows owners to purchase much-needed equipment and machinery for their operations. Businesses can use a loan to pay for office equipment and devices for employees or to manufacture products.
The size of the loan is determined by the value of the equipment it is being used for. Unlike other loans, businesses must make a down payment before receiving the loan. Most equipment-financing lenders have term limits of up to 25 years.
Merchant cash advances
A merchant cash advance allows businesses to access a lump sum of cash via a lender in exchange for a portion of their future sales. Unlike typical business loans, a cash advance is repaid through business sales on a routine basis. This is a good lending option for small businesses that need access to cash quickly and that generate a high volume of sales.
Specialty loans
Specialty loans are approved for businesses that meet certain requirements. These loans can be based on the owner's age; gender; ethnicity; or the industry the business operates in, such as the medical, agricultural, or nonprofit fields.
These loans are not available to everyone, but they can be a helpful resource to a business that is eligible for one. The SBA, for example, offers several funding programs for minority-owned small businesses.
[Read more: Secured vs. Unsecured Business Loans: What You Should Know About Each]
The most common type of SBA loan is the SBA 7(a) loan. The 7(a) loan has a maximum limit of $5 million and is generally used to purchase real estate, as well as for working capital and debt refinancing.
How to choose a small business loan
As you research small business loans, ask yourself the following questions to help you choose the right type of loan and lender.
How much money do I need, and how will I use it?
These two questions go hand in hand and will be asked on a business loan application, so you want to have your answers prepared. Different types of loans can only be used for specific purposes, like purchasing equipment or investing in major assets, which may rule out certain loan products for you. Additionally, some lenders only issue loans up to certain amounts, so it's important to know whether a specific loan product will meet your needs before you apply.
How much can I afford in monthly payments and interest?
Evaluate your cash flow and business credit to ensure the amount you plan to borrow is manageable and that you can afford to pay it back. Pay close attention to the loan amount and terms, as interest payments and potential penalty fees can add up quickly.
You can use a business loan calculator to estimate your monthly payments with different loan amounts and interest rates. Before committing to a loan, secure multiple quotes to compare repayment terms and lender fees to guarantee you get the best loan offer for your business.
Do I want to work with a traditional or an alternative business lender?
Traditional lenders like banks and credit unions generally offer loans with better terms but a slower and more rigorous approval process, while alternative or nonbank lenders usually have more relaxed criteria and faster approvals but higher interest rates. There are pros and cons to each type of lender, so you'll want to choose the one that best suits your current business needs and financial circumstances.
Most importantly, you want a reputable, trustworthy lender, regardless of whether they are a traditional or an alternative lender. You can explore lender options online, through the SBA, and via referrals from trusted industry contacts. Compare eligibility criteria and check online reviews to see what other small business customers say about the lender.
[Read more: 4 Mistakes to Avoid When Applying for a Small Business Loan]
How to qualify for a small business loan
While some loans have specific requirements, business owners typically must meet several criteria to qualify for most loans. These eligibility criteria include the following:
- A business plan. A business plan spells out your strategy to lenders, proving that you have a clear strategy for the funding you are requesting. It outlines your current financial status, details how the loan will be used, and includes revenue forecasts and a repayment strategy.
- The industry type. The loans you qualify for and the lenders you work with will depend on your industry, as different sectors carry varying degrees of risk. Additionally, some lenders specialize in exclusively financing specific industries.
- The business's tenure. Your business's history is considered when applying for a loan. Often, online lenders require businesses to operate for at least six months, while traditional lenders may require a minimum of two years.
- Annual revenue. Lenders review annual revenue to ensure enough money is coming into the business to make repayments considering such metrics as your debt-to-income ratio. For many small business loans, companies must have at least $100,000 in annual revenue.
- Personal and business credit scores. Lenders consider your personal and business credit scores when applying for a loan. These scores reflect the level of risk you represent; a healthy score can lead to lower interest rates and increase the likelihood of approval.
- Collateral. Because lenders take risks when granting loans, many secure loans require collateral or a personal guarantee to repay the money. Collateral involves offering business or personal assets the lender can take possession of if your business cannot repay the loan.
In addition to these criteria, businesses must provide legal and financial documentation, including tax returns, licenses, leases, and financial statements, when applying for a small business loan.
[Read more: 6 Documents to Prepare for a Small Business Loan Application]
Other business finance options
If you are denied a business loan, you can pursue one of these other financing options:
- Government and private grants. Countless grant programs exist for small businesses that meet certain requirements. These grants are typically funded by the government or by private corporations and don't require recipients to repay the funds they receive.
- Lines of credit. A line of credit allows businesses to withdraw the amount of cash they need and only pay interest on the money they take out. This is a flexible option for businesses that need extra cash occasionally.
- Invoice factoring and financing. An invoice factoring company fronts you money for your unpaid invoices, minus a fee, so you can get quick access to cash. Then your customer directly pays the full invoice amount to the invoice factoring company.
- Crowdfunding. Crowdfunding campaigns through sites like Kickstarter and Indiegogo have become a popular way for businesses to raise money. Crowdfunding involves pitching backers who contribute a small amount of money in exchange for incentives like free products/services when the business launches or a stake in the company (if it's through an equity crowdfunding platform).
This article was originally written by Dan Casarella.
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