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Small business loans come with a lot of advantages – they can help you finance projects, purchase equipment, and get working capital when you don’t have enough cash flow. But taking out a loan comes with some downsides, too, including the risk that you could default on your payments and lose any asset you put up as collateral.To figure out if taking out a small business loan is the right move for your company, read on. Below, we break down the pros and cons of small business loans.
What is a Business Loan?
A business loan is money a business owner receives from a lender to invest in their business or to use for business-related purposes. A business term loan is paid back over a set amount of time, with regular repayments deducted from your business checking account. Business lines of credit work similarly to credit cards.Recommended: Applying for a Small Business Loan in 6 Steps
Benefits of Small Business Loans
There are many benefits to taking out a small business loan. Here are a few to consider.
1. Expedite Your Business’s Growth
If used wisely, a business loan can jumpstart your company’s growth. The funds from a business loan can allow you to put your plans into action sooner, rather than having to wait until your business has generated enough profit to fund expansion yourself.
2. You Don’t Have to Dilute Your Equity
A business loan allows you to get an injection of cash without bringing on any investors. This enables you to keep full control of your business and retain all the profits as your company grows. Once you take on an investor, that investor will get a percentage of your profits as long as your business is in operation. A loan, on the other hand, is a temporary measure. Once you pay it off, you will have no more obligation to the lender.
3. Overcome Cash Flow Issues
Any small business can hit a cash flow hiccup. This is especially common when a small business is experiencing rapid growth, since you may need to take on more employees and/or buy more equipment and materials in advance of getting paid. A loan can smooth out these ripples.
4. Flexible Use of the Funding
If you receive funding from an investor, it’s possible that the investor will have a say in how you use the money and could place restrictions on what it can and cannot be used for. When you borrow from a lender, so long as the loan isn’t specifically for business equipment or real estate, there are typically no restrictions on how you can use the money.
5. Can be Less Costly Than Other Forms of Borrowing
Business loans can often be a better value than using credit cards, overdraft, or a personal loan to get the funds you need. This is especially true if your business has been in operation for a number of years and has a strong credit profile or you opt for a secured loan (meaning you put up collateral), as both can help you get a low interest rate.Recommended: Your Guide to Peer-to-Peer Business Lending
Disadvantages of Small Business Loans
While there are many business loan benefits, there are some potential downsides. Keep these in mind before you make your final decision.
1. Extensive Application Process
Since lenders extend commercial financing based on your company’s ability to pay, they’ll typically require extensive paperwork during the application process. You’ll not only need to fill out an application, but will also likely need to provide two or three years of tax returns and financial statements, as well as a business plan.
2. You Could Lose Assets if you Default on Payments
To ensure their investment is secure, many financial institutions require business owners to offer some form of collateral in case you can’t make your payments. If you put a business asset up for collateral, you could end up losing it should you default on the loan. In some cases new business owners need to use personal assets (such as a house) as collateral. In that scenario, you could risk losing your home.
3. You Will Need a Strong Credit Profile
Interest rates typically depend on your credit score, both your business’s score as well as your personal score. While banks often offer lower interest rates than other funding options, it’s not always easy to qualify for those favorable rates. If you have a below-average rating, you could end up paying more for the loan than you’d like.
4. You May Not Get the Money for a While
The underwriting process is typically longer for a business loan than other types of loans. For the highly desirable SBA loans (which are backed by the U.S. Small Business Administration), it can take several months to get approved and receive any funding from the lender. If you have an immediate need for cash, a business loan may not be the best option for your company.
5. Lack of Flexibility With Repayments
With most commercial business loans, the terms aren’t flexible. You’ll borrow a set amount of money, make regular pre-determined monthly payments, and will be expected to repay the loan in an agreed upon time frame. If your small business revenues tend to fluctuate, a required monthly payment may not be ideal.
Weighing the Pros and Cons
As you can see, there are many business loans advantages and disadvantages, so the key question you may want to ask is, how will you use the money? It can even be smart to write up a business plan that outlines exactly how you would use the funding from a loan, and how you anticipate the money would increase profits. The great part about doing this is that you will be able to use this business plan when applying for the business loan itself.
Benefits of Business Loans
Drawbacks of Business Loans
Can fuel business growth
Long application process
Keep your equity
Could lose assets if you default on payments
Increase available cash
Will need a strong credit score
Money can be used for a wide variety of purposes
May take months to get money
Different Types of Business Loans
There are many different types of small business loans. It’s important to understand how each loan works, so you can choose the best option for your business. Here’s a look at 10 different types of small business lending options.
SBA Loan
If you have strong credit, you may want to look into an SBA loan, such as the popular SBA 7(a) program. SBA loans stand out among small business loans due to their favorable terms – low rates, high amounts, and long payback periods. They are also highly competitive, which is why you need a high credit score to be considered a candidate.
Microloans
Microloans are typically offered through nonprofits or the government, like the SBA. These lenders provide business loans of up to $50,000 to startups and small businesses, many of them run by women, minorities, or veterans. This can be a good option if you need a smaller amount of capital to purchase equipment or hire help and your business doesn’t have a long (or any) track record.
Business Credit Cards
Business credit cards are revolving lines of credit. You can draw from and repay the card as needed, as long as you make minimum monthly payments and don’t exceed the credit limit. While interest rates tend to be much higher than small business loans, you may be able to get a 0% APR credit card that offers no interest for a fixed period.
Business line of credit
Similar to a credit card, business lines of credit provide borrowers with a revolving credit limit that you can generally access through a checking account. You can spend up to the maximum credit limit, repay it, then withdraw more money.
Term Loan
Term loans are one of the most common types of small business loans and issue a lump sum of cash that you repay over a fixed term. The SBA loans mentioned above fall into this category, but you can also find term loans not backed by the SBA that may be easier to qualify for. The lenders who offer these loans determine rates and terms based on your creditworthiness.
Merchant Cash Advance
This type of cash advance requires you to borrow against your future sales. In exchange for a lump sum of cash, you’ll repay it with either a portion of your daily credit card sales or through weekly transfers from your bank account. Like traditional cash advances, merchant cash advances tend to come at a high cost.
Commercial Mortgage
If your business wants to acquire commercial property — such as a retail shop, office building, or manufacturing facility — you’ll likely want to opt for a commercial mortgage (also known as a commercial real estate loan). These loans typically act like term loans, with the underlying property acting as collateral.
Equipment Loan
If you need a loan to purchase a piece of equipment for your business, an equipment loan can be a good option. Unlike some other types of business loans, business owners with less-than-ideal credit can often qualify for equipment financing because the equipment itself secures the loan. However, if you default on the loan, the lender can seize the asset.
Invoice Factoring
If your company has a lot of unpaid invoices but you need cash now, you can get money for those unpaid invoices through invoice factoring. You’d sell the invoices to a factoring company (for less than than their full value). That company would then be responsible for collecting from the customer when the invoices are due. This can give you access to fast cach but tends to be costlier than other forms of financing.
Invoice Financing
Invoice financing is similar to invoice factoring, but instead of selling your unpaid invoices to a factoring company, you use the invoices as collateral to get a cash advance. Your customers don’t know their invoice is being financed and you are still responsible for collecting on those invoices. Like invoice factoring, this can provide you with quick cash, but tends to be costlier than other forms of financing. Here’s a chart to help you compare small business loans.Here’s a quick recap of the advantages and disadvantages of loans in business:
Loan Type
Pros
Cons
SBA Loan
Some of the lowest rates on the market.
Long repayment terms
Hard to qualify
Long and rigorous application process
Term Loan
Get cash upfront to invest in your business
May be able to borrow a higher amount than with other types of loans
Funding is fast if you use an online lender
May require a personal guarantee or collateral
Costs can vary (term loans from online lenders tend to have higher costs than those from traditional banks)
Business Line of Credit
Flexible way to borrow
Typically no collateral required
May carry additional costs (like maintenance fees)
Strong revenue and credit required
Equipment loan
You own the equipment and build equity in it
You can get competitive rates if you have strong credit
You may have to come up with a down payment
Equipment may become outdated before the loan term ends
Merchant Cash Advance
Unsecured financing
Some of the highest borrowing costs
Frequent repayments can be hard to manage
Invoice Factoring
Quick cash
Easier approval than traditional funding options
Costly compared with other options
You lose control over the your invoice collection
Invoice Financing
Quick cash
Your customers won’t know their invoice is being financed
Costly compared with other options
You’re still responsible for collecting on invoices
Commercial Mortgage
Property you purchase will be an asset that may increase in value
You don’t have to worry about rent increases
Large up-front cost (significant deposit, plus fees)
Typically not an option for newer businesses
Business Credit Card
May be able to get a card with an introductory 0% rate
No collateral required
Can be high cost, with a variable rate that may rise
Extra fees may apply
Microloan
Low cost
Other services may be provided (like consulting and training)
Smaller loan amounts
You may have to meet strict eligibility requirements
Alternatives to Business Loans
If you’re open to outside investors, you might also look into angel investors – these are wealthy individuals who provide their own funds. They are looking for a high rate of return, and so tolerate high risk. Venture capitalists (companies who use investors' funds instead of their own) are another option. They typically offer more money than angel investors, but tolerate less risk.You might also consider crowdfunding, which involves raising small amounts of money from a large number of people via a crowdfunding platform. Small business grants can also be a way to get capital for your business. These don't require repayment, but your business must typically serve a particular purpose as outlined by the government to qualify.
The Takeaway
There are advantages and disadvantages of taking out a small business loan. On the positive side, a small business loan can help grow your business without diluting its ownership. A loan also gives you the flexibility to use the funds as you see fit. And, if you have strong credit, you may qualify for favorable rates and terms.The main disadvantage of a business loan is the risk involved. If you are unable to make the monthly payments you agreed to, you could lose any business or personal collateral you put up for the loan. If you think the pros of business financing outweigh the cons, a good next step is to see what type of business loan you may qualify for. With Lantern by SoFi, you can quickly compare offers from multiple small business lenders without any obligation and just one application.
Frequently Asked Questions
What are the advantages of taking out a small business loan?
What are the disadvantages of taking out a small business loan?
What should you know before applying for a business loan?
Photo credit: iStock/grandriver
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About the Author
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.
