How Business Loans Work

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How Business Loans Work

Small businesses embody the American dream. They symbolize financial and social success through hard work, determination and good old know-how. They help entrepreneurs accomplish their dreams in a way that benefits not only them personally, but society as a whole.

The problem with dreams like this is that they cost money. And unless your family name is also on several performance halls and university buildings in your hometown, you probably don’t have the cash on hand to start your dream business.

Most of us don’t have it just sitting around it our savings accounts either. So what does an enterprising American with great ideas and not-so-great account balances do? They borrow. In other words, they get a small business loan. But how do business loans work?

If you’re not familiar with the crazy, complex world of corporate financing, it can be a little overwhelming. To help explain your options, here’s a quick guide to the most common types of small business loans. But first, let’s talk about exactly what a business loan is.

What is a Business Loan Anyway?

A business loan is when a lender – usually a bank or other financial institution – lends you a large sum of money to finance your small business dreams. When you secure this type of loan, you agree to pay the money back over time, with interest. Okay… so what’s interest?

Interest is like rent on money, an extra percentage you pay on top of your loan amount so the lender can make a profit. This percentage is known as an Annual Percentage Rate, or APR. Federal laws limit how much a lender can charge by way of an APR, but anything 10% or below is reasonable, so keep this in mind as you work toward better understanding how business loans work.

Sometimes you’ll need to put up collateral for a business loan, some sort of asset that the lender can get money from if you can’t pay it back. Houses are a popular form of collateral, but investments, securities, and other high-value items can be used as well.

In most bank loans you are expected to personally guarantee the loan, meaning the banks can come after you if the loan goes into default (if you quit making payments as agreed to the initial terms of the loan). If your credit isn’t up to snuff, they may also ask for a cosigner, meaning that person is on the hook for the loan as well.

Additionally, some companies organized as LLCs will try and guarantee loans as well, but because small businesses have such a high failure rate, banks may ask you to personally guarantee it as well.

Certainly, this leaves a lot for you to consider when it comes to how business loans work, but that’s not all. You must also decide which type of loan you want to finance your small business venture, leading us to the next question…

What Kinds of Business Loans Are There?

The first and most obvious type of business loan is a standard bank loan, where an entrepreneur walks into a bank with a well-detailed business plan, and asks that bank for money. These loans typically have the lowest interest rates and are the most straightforward, but about 80% of small business loan applicants are rejected. Why?

Put simply: Banks aren’t charities. This means that, unless your business plan looks like a guaranteed winner – or you’ve got rock-solid collateral – you may need to look elsewhere for help. Enter the Small Business Administration.

The SBA, as it’s known, isn’t a lender but rather a federal agency that helps small businesses by guaranteeing the loans for them. These loans still require an application (and get rejected all the time), but are a much higher-percentage shot. So how do these business loans work?

Essentially, the SBA reviews your application, and if it’s approved the SBA will back up to 85% of your loan. Since the government is guaranteeing the loan, banks are much more likely to give you the money you need.

The Most Common SBA Loans

The most common SBA loans are the 7(a) group, the most popular of which is the General loan. This is where the SBA can guarantee up to 85% of loans under $150,000, and 75% of loans over that amount, up to $5 million.

Another option is CAPLines loans, a loan and line-of-credit program designed to give small business owners short term loans for immediate needs. These loans can be guaranteed up to $2 million, and also fall under the 7(a) category.

There are five different types of CAPLines loans:

  1. Seasonal line of credit, for high volume times when you may need cash to invest in inventory and personnel.
  2. Contract line of credit, designed for contractors who need money to fulfill contractual obligations before they are paid.
  3. Standard asset-based line of credit, designed to give a financial boost to companies who don’t have acceptable credit for long-term loans
  4. Small asset-based line of credit, which are loans up to $200,000 with lesser requirements than the standard asset-based
  5. Builder’s line of credit, primarily for construction companies renovating existing commercial spaces.

Finally, 7(a) loans also include the SBA Express program, which allows approved institutions to use their own paperwork and attach it to an SBA approval for amounts under $350,000. These applications move exponentially faster than general SBA loans, but are only guaranteed up to 50%.

The SBA also has a Micro Loan program, where the SBA loans money to nonprofit intermediaries who in turn loan the money to entrepreneurs, in amounts under $35,000. The other end of that range is the CDC/504 loan, a long-term fixed-rate loan used for asset purchases like real estate or expensive equipment. This tops out at about $5 million, or $5.5 million for manufacturers.

Other Types of Business Loans

Borrowing money, of course, is not simply limited to banks and SBA loans. Many other options exist for small businesses. A few examples:

  • Equipment financing – This is specific financing set out for large equipment purchases, with the equipment itself held as collateral
  • Invoice financing – Essentially selling some accounts receivable to a lender in exchange for cash on hand. The cash will be considerably less than the total of the invoices, however.
  • Short term business loan – A high-interest, short-term loan for smaller amounts that is paid back in as little as a quarter
  • Merchant cash advance – You receive cash in exchange for a portion of future credit card sales.

Alternative lenders like BFS capital also offer loans to small businesses, as well as merchant cash advances and other services. This is an excellent option if your credit won’t allow you to qualify with other lenders, and if you need capital quickly.

Which Business Loan Is Right for You?

If you’re still unsure which business loan is right for you, look at your different options and compare and contrast the pros and cons of each to better decide which solution is best for your small business. Consider what your interest rate will be, how much the lender is willing to give you, and all of the other payback responsibilities you’ll have should you decide to take that route.

No matter which option you choose though, at least now you know what the process is all about. So, no more asking, “How do business loans work?” Instead, it’s time to ask, “Which one offers me what I need to help me grow my business now, providing the best terms possible given my situation?” Answer that and you’ll know which one suits you best.

 


Matt Meltzer

Matt Meltzer is a professor of business communication at the University of Miami. He is a veteran of the United States Marine Corps and holds a bachelors degree in business administration from UM, as well as a Masters of Mass Communication from the University of Florida.

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