The Complete Guide to Small Business Loans

Business Loans

An idea is the first seed of all business growth. Ideas about products or services that makes people’s lives so much better they’re willing to pay for them. Take the screen you’re reading this article on, which is likely to be an iPhone according to our website metrics. That iPhone didn’t begin in a factory or boardroom. It was an idea in the heads of Steve Jobs and his Apple technicians (and even still, the true credit for the iPhone remains up for debate.)

Of course, Steve Jobs had no problem accessing capital once an idea popped into his head. Not all business owners are so lucky and many ideas don’t ever have the financial backing to get off the ground. The great thing about ideas is that they’re free – but after that, you need a plan and the money to put it in action. Thankfully, banks offer loans to creditworthy businesses, but the process is different than your standard personal loan application. In this guide, we’ll discuss the basics of business loans, institutions that offer (or facilitate) them, and what you’ll need for approval.

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What Are Small Business Loans?

According to the Small Business Administration, over 99% of all U.S. companies qualify as small businesses. Small businesses often use family savings to get off the ground, but many need loans for startup costs like real estate and inventory.  Business owners borrowed over $600 billion from U.S. financial institutions last year. But since most small businesses are sole proprietors or non-employer firms, that $600 billion went to only 8% of U.S. small businesses.

How do business loans work? Pretty much the same way personal loans do, just with better interest rates, more cash, and a truckload of excessive paperwork. You’ll apply for a loan from a lender, usually a bank. But instead of looking at your personal credit history, a bank wants to know your business plan and profit strategy. Oh, and they’ll still check your personal credit history too. This increased scrutiny comes with benefits, though. Banks hand out way more capital to businesses than individuals and at much better rates.

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Why Do I Need A Small Business Loan?

Businesses take out loans for all sorts of things. If you’re just starting your business, you’ll likely need equipment, space, and capital for expenses. But if you don’t yet have profits, you’ll need to get the cash elsewhere. And if you don’t have savings, a business loan might bridge the gap between brand new company and profitable firm.

Startup costs are one of the many reasons companies appreciate access to quick capital. Loans are often available within a few days, so business owners can put the money to work right away. And unlike credit cards, business loans have cheap interest rates for creditworthy borrowers. Here’s a few of the most common uses of business loans:

  • Equipment – If you run a machine shop, your equipment is obvious: mills, shearers, drill presses, etc. But equipment also includes computers, smartphones, and other electronics, plus cars and trucks. Basically anything that can wear out is considered business equipment by the IRS. You can’t start a business without the proper tools, so loans are often used for necessary equipment.
  • Inventory – Inventory falls into three basic categories: raw components, in-process goods, and completed products. Before you can sell a product, you need the parts to build it.
  • Property – Companies with many employees need a place for everyone to work. Business loans are often used to rent buildings or office spaces for expanding firms.
  • Debt Consolidation – Not everyone uses a business loan to pursue an exciting new opportunity. Some business just want to get a handle on their debt load. Business loans are often used to consolidate credit card balances or other high interest loans.
  • Administrative Expenses – The IRS considers business supplies to be separate from equipment. It might not matter much when you take out a loan, but you’ll need to make the distinction on your tax forms.

The average size of a business loan is $633,000, although the median is under $250,000. You might be surprised how much a large bank is willing to offer if you have impeccable credit and a solid business plan.

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Who Offers Loans to Businesses?

Business loans come from three main sources:

  • Banks – The primary source of business loans; banks of all shapes and sizes lend to businesses. Large national banks usually have the best rates, but only for the most creditworthy customers.
  • Online Lenders – The internet has given birth to dozens of online alternative lenders like LendingClub, SoFi, and LightStream. Many of these companies are peer-to-peer lenders, which means they’re not actually lenders at all. Instead, they act as a marketplace where borrowers can pair up with lenders and make agreements. Other online lenders like Marcus are backed by the heavy pockets of Goldman Sachs.
  • Credit Unions – You have to be a member of a credit union to access their loans, but initiation is usually cheap and easy. Credit unions are nonprofit and often offer superior rates to their banking counterparts. Plus, they’re more likely to offer financial education and counseling to their customers.

Many prospective business owners think the SBA supplies loans, but they actually don’t lend any money. The SBA is a middleman helping facilitate deals between lenders and businesses looking for capital. Cutting out the middleman is usually good business strategy, but this is an intermediary you’ll want to talk shop with.

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The SBA’s Role in Securing Business Loans

In 1953, President Eisenhower signed the Small Business Act into law, and with it came the creation of the Small Business Administration (SBA). The SBA has a mandate to cultivate small business in the United States through the three C’s: counseling, contracts, and capital. The SBA gives business counseling to new companies and helps them get funding through different loan programs. They also provide government contracts to small businesses.

Contrary to popular belief, the SBA doesn’t lend out money. Instead, they match lenders and borrowers through different business funding programs. Here are the main SBA loan programs:

  • 504 Loan Program – With 504 loans, the SBA sets small businesses up with what’s called a Certified Development Company (CDC). CDCs are regulated by the SBA to help small businesses meet their funding needs. With a 504 loan, you can borrow up to $20 million, but the money must be used on fixed costs like real estate and equipment. The smallest amount you can borrow is $125,000. Rates are fixed between 4 and 5 percent with a max term of 20 years. Typically, 504 loans involve both a CDC and a bank. The bank provides 50% of the loan, the CDC chips in 40%, and the business owner guarantees the final 10%. Only for-profit businesses with a net worth less than $15 million qualify for 504 loans. All owners with at least 20% equity must sign a personal guarantee. The company must also occupy 51% of all property purchased or leased with the loan funds.
  • 7(a) Loan Program – The 7(a) program is the bread and butter of the SBA. Far more companies qualify for these loans than 504 loans and 7(a) loans can be used for a multitude of expenses. Loans amounts are capped at $5 million, but they can be used for inventory or debt reduction (unlike 504 loans). The average amount awarded is between $30,000 and $50,000 and the typical term is about 7-10 years, but can be as long as 25 years if used for real estate. Fixed and variable rate 7(a) loans are available with the average interest rate settling between 8% and 10%. To qualify, you must be a registered for-profit small business in the United States with good credit, minimal debt, and sufficient cash flow.
  • Microloan Program – Mainly used for startups, microloans are smaller loans given to businesses that only need a little bit of cash. The largest amount is $50,000, although the average is only $13,000. Average term for microloans is only 6 years, but interest rates are higher, ranging from 8% to 13%. Startups have to inject 25% collateral, but companies with two years of business history only need 10%. Community involvement is a key factor here, so businesses in economically-disadvantaged areas have the best approval odds. Microloans can’t be used for debt payments or real estate purchases. Like 504 loans, all 20% equity owners must sign a personal guarantee.
  • Disaster Loan Program – The most rarely used SBA program (thankfully), disaster loans are only for businesses within declared disaster areas. These loans have the loosest rules for use; anything damaged in a natural disaster can be repaired or replaced with disaster loan funds. Interest rates are capped at 4% for businesses with no other credit sources.

SBA loans come from banks and other lenders, but they’re partially guaranteed by the government to help new businesses get better rates. Getting one can be difficult though. Only 10% of applicants are approved, so the SBA programs are like exclusive clubs. Make sure you have two years of business history, a solid credit history, sales projections, and a detailed business plan. There’s paperwork and fees too, of course. You can find the necessary forms through the SBA’s website here.

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Requirements for Getting a Business Loan

Applying for a small business loan will often feel like an interrogation. Prepare as much paperwork as possible because lenders will examine every aspect of your business. Not every lender has the same requirements, but to be safe, keep copies of the following documents handy:

  • Business and personal credit scores
  • Business plan
  • Income statements
  • Balance sheets
  • Bank reports
  • Credit card statements
  • Tax returns
  • Legal documents
  • Copies of your lease or rental agreement
  • Proof of loan collateral

Exhausted yet? Business loan applicants face more scrutiny than personal loan applicants. After all, business owners are usually asking for a much larger load of cash. To boost your chances of approval, make sure your business plan details what you’ll be using the cash for. Banks look for companies with solid credit, strong sales growth, and at least 2 years of business history. If you have a credit score under 700, try to boost it before applying for a loan.

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What To Consider Before Choosing a Lender

Despite the tedious paperwork, remember you’re the customer here. Shop around to find the lender offering the best deal. Consider all factors of the loan: interest rate, terms, fees, prepayment penalties, and your company’s business outlook. Before applying, ask yourself these questions:

  • What happens if I have trouble repaying?
  • Can I refinance this loan later?
  • What other methods of financing are available to me?

The average interest rate on bank business loans hovers between 2.5% and 5.5%, but only the most creditworthy businesses get those rates. For new businesses, they can be as high as 13%, which demonstrates why SBA loans are so appealing.

Business loan approval rates are beginning to hit all-time highs. Those all-time highs are still only 27% at large banks and 40% at credit unions, though. Alternative lenders approve more than half their applicants, but attach high fees and interest rates to their loans. Getting denied for a business loan is common, so don’t get discouraged if it happens. You can always apply again later. Or you can try another method of financing like invoice factoring, cash advances, or business credit cards. Remember, getting a business loan requires preparation, paperwork, and patience. The more meticulous and thorough you are, the more you’ll increase your odds of getting the funding you need.

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June 21, 2019

Dan is a financial research and analysis expert.  He has been sharing his research on personal finance for years and has previously been published on Benzinga and Loan Gifting. 

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