How Exactly Do Small Business Loans Work?

How Do Business Loans Work?

Lauren Ward

Lauren Ward

Updated February 19, 2022

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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

The right business loan can give you the capital you need to get a new venture off the ground, expand a current business, or help cover everyday operating expenses.There are many different types of small business loans, however, each with their own eligibility requirements, costs, and repayment schedules. To learn exactly how business loans work, and which type of loan might be a good fit for your needs, read on. Here’s what you need to know about finding and applying for a small business loan.

What Is a Small Business Loan?

A small business loan is money that is loaned to a small business owner by a bank, credit union, or online lender, and must be repaid. The money can be used for any business-related expense that will aid the growth and continued operation of the business. Some owners need loans for everyday transactions, while others are looking for loans for business expansion.Here are some examples of what a small business loan can be used for:

Commercial real estate
Operation expenses
Debt consolidation
Equipment purchases
Equipment repairs
Refinancing
Inventory purchases
Startup costs
Research and development
Launching a new division or product line
Marketing and advertising

How Do Small Business Loans Work?

Small business loans typically work in a similar way to personal loans. You submit an application for a specific amount to a lender, who looks at your financials and decides how likely you are to repay the loan. If approved, you will be given an interest rate that is in line with your credit score — meaning if you have a strong credit score, you’ll likely be offered a lower interest rate and vice versa.Also like a personal loan, your business must pay back the loan in a set amount of time, often with predetermined monthly payments that go towards both your loan’s interest and your loan’s principal.If you fail to keep up those monthly repayments, it could mean that you are charged a late or missed payment penalty fee or could lose any assets which you put up as security for the loan.While some small business owners worry about whether business loans are considered income, the good news is that, no, a business loan is typically not considered taxable business income. The reason is that this money will be paid back. What’s more, the interest you pay on a business loan is generally tax deductible, which means that it can reduce your taxable income and overall tax liability.

How to Find The Right Business Loan

There are many kinds of loans on the market. In order to find one that meets your needs and qualifications, here are some important things to consider.

What Do You Need It for?

To find the right business loan for your company, you must first determine what the money is going to be used for. For example, if you need it to purchase equipment, then you’ll most likely want to pursue an equipment loan. These loans often come with good rates and terms because the equipment can be used as collateral.At the same time, you’ll want to think about how much money you’ll need to accomplish your goal. Whatever amount you come up with, you may want to add a bit of padding, since costs can rise unexpectedly.

What Do You Need to Qualify?

Understanding a lender's minimum requirements and qualifications can increase your chances of getting approved for a small business loan. While some lenders may be flexible, many require that borrowers meet a minimum credit score, annual revenue, and number of years in business.Loans backed by the U.S. Small Business Association (SBA) tend to have the strictest requirements, while small business loans from direct online lenders and peer-to-peer lending sites are often less stringent.

Key Terms

Before you start comparing business loans, it’s important to understand a few key business loan terms. Here are a few to become familiar with.

Repayment term: the amount of time that a borrower has to pay back the loan.
Fees/penalties: extra costs on top of the interest that you may need to pay, such as application fees, origination fees, and late fees.(All small business loan fees are usually listed in the loan agreement.)
Eligibility requirements: conditions the bank or lender requires the borrower to meet in order to qualify for financing.
Interest rates: what the lender charges for giving you access to the money, expressed as a percentage of the loan amount.
Principal: the total amount of money you are borrowing (not including interest).
Time to funding: how long it will take for the lender to distribute funds to the borrower.

Types of Lenders That Offer Business Loans

Direct Online Lenders

You can apply directly with an online lender instead of working through a traditional bank. The benefit of doing this is that many online lenders have advanced technology that enables them to quickly approve borrowers and transfer funds. The drawback is that it’s not uncommon to get charged higher rates when working with a direct online lender as opposed to a traditional bank.

Large Commercial Banks

Large commercial banks are known for issuing loans with lower interest rates than their peers, but the drawback is that they tend to have strict qualification requirements that can be difficult to meet. If you’re a new business, large commercial banks may be outside of your reach.

Large Community Banks

Community banks are locally owned and operated. Since they tend to be smaller than commercial banks, they can often provide you with more individualized service. These banks may also look at other aspects of your business besides your credit score.

Peer-to-Peer Lending Sites

With peer-to-peer lending sites, any money you receive comes from a group of investors as opposed to a single lender or a bank. Peer-to-peer loans are often easier to qualify for, but tend to cost more in the long run due to fees and higher interest rates.

SBA-Backed Banks

SBA loans are backed by the Small Business Administration. Since they present less risk to the lender, these loans tend to come with lower interest rates and longer terms. However, they also typically come with strict eligibility requirements.

Comparing Business Loan Options

All business loans are not created equal. Here are some things to consider when comparing business loans.

Interest Rate Need-to-Knows

Some loans have fixed interest rates, while others come with a variable interest rate. A fixed business loan carries a set interest rate that remains the same over the life of the loan. Your loan payments will be the same each and every month until the loan is paid off.An adjustable rate business loan starts with a set interest rate that changes based on current market rates at a predetermined date. After that date, your monthly payments could be more, or less. Before choosing which one you want, it can be a good idea to do some research on average small business loan interest rates.

Early Payments

Some lenders charge a prepayment penalty if you pay off your loan early, while others do not. A loan with higher interest rates but no prepayment penalties could potentially be a better deal if you think there is a high chance you will pay the loan off early.

Late Payments

Find out what the fee is for making a late payment. How long do you have before you’re charged a late payment fee?

Default

It’s a good idea to find out what a lender considered a loan “default.” In some cases, it only takes a small change in cash flow to potentially put your business in jeopardy. Of course, if you are ever in danger of defaulting, it’s always a good idea to speak with your lender early on, as they may be able to help.

Applying for a Business Loan

Once you find a loan that you are interested in, the next step is to fill out an application. When you apply for a small business loan, you typically need to provide the following paperwork:

I.D.
Bank statements
Proof of Ownership
Balance sheet
Personal tax returns
Business tax returns
Profit and loss statements
Voided business check

Once you have all your documents in order, how you’ll actually apply for the small business loan will depend on the lender. With online lenders, you can typically do everything (not surprisingly) online. More traditional financial institutions, such as banks and credit unions, however, may require you to apply at a branch or over the phone.Either way, make sure to double-check that your business loan application includes everything the lender asked for and in the appropriate format. This can help reduce any unnecessary back and forth, so you can get a decision as quickly as possible.

Pros and Cons of Business Loans

Like any financial product, there are pros and cons of small business loans that you may want to consider before signing any loan agreement. Here’s a look at how they stack up.

Types of Small Business Loans

There are various types of business loans and it’s important to understand how each one works, so you can choose the best option for your business. Here’s a look at some common small business lending options.

Small Business Line of Credit

A business line of credit is similar to a credit card. You can borrow up to a certain limit and you only pay interest on the amount of money you borrow. If you take out a small business line of credit, you'll be able to draw funds and repay them as often as you'd like as long as you don't go over your credit limit.

Accounts Receivable Financing

With accounts receivable financing, also known as invoice financing, you use your unpaid invoices as collateral to get a cash advance. Typically, invoice financing companies advance you a large portion of the value of your invoices. You receive the remaining percent (minus fees) when your invoices are paid. This can provide you with quick cash, but can be costlier than other forms of financing

Working Capital Loans

If you just need a small amount of cash to keep your business operating smoothly, a working capital loan may be a good fit. However, keep in mind that repayment periods are short and interest rates can sometimes be higher than with other types of business loans.

Small Business Term Loans

Term loans let you borrow a set amount of money that’s paid back with interest on a predetermined schedule. Both long-term and short-term small business loans are available. Which type will work best for you will depend on your business’s needs.

SBA Small Business Loans

These term loans are offered through a lender that is insured through the SBA. Should the borrower default, the SBA will repay the lender a majority of the debt. Because SBA loans are government-backed they come with lower interest rates and better terms for borrowers. However, they can be hard to qualify for.

Equipment Loans

If you’re looking to purchase a new piece of equipment or machinery, you might consider equipment financing. With this type of small business loan, you typically get a quote for the equipment you’d like to buy, and a lender will front you a significant portion of the cost. The asset you purchase with the loan acts as collateral for the loan.

Small Business Credit Cards

A business credit card is similar to a personal credit card, except it may provide you with reporting features so you can categorize and track your spending, as well as a rewards program that can help you save on common business expenses. There are also some 0% APR credit cards that offer no interest for a fixed period (often longer than a year).

The Takeaway

Business loans are a form of credit offered by lenders to businesses. In exchange for this money, lenders require repayment of the principal with interest and fees added to it. Usually, business loans require the borrower to make regular payments on a set schedule, but repayment terms and interest rates can vary depending on the lender and your business’s qualifications.If you’re interested in finding out what type of loan you may qualify for, Lantern by SoFi can help. With our easy-to-use online tool, you can compare offers from multiple small business lenders without any obligation and just one application.

Photo credit: iStock/shapechargeThe tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice. SOLC1221004

Frequently Asked Questions

How much income is needed for a business loan?

What are the rules for business loans?

How do you pay back business loans?

How long are business loan terms?

Can you get a business loan with no down payment?

Do banks give loans to start a business?

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.

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