Both small business loans and advances can provide outside funding for small business owners. But it’s important to understand the differences so you can make the best choice.
Small Business Loans
With a small business loan, the lender and applicant agree on repayment terms for a specified amount of money. The terms include the interest rate and repayment schedule, which can vary from monthly installments to one lump sum. For fixed interest rate loans, the rate stays the same for the loan duration. For variable interest rates loans, rates can fluctuate based on defined determinants, such as the prime interest rate. When getting a loan, you also need to factor in extra charges, such as application fees, which can add to the costs.
Before receiving the funds, you are generally required to sign a promissory note that lays out the terms in writing. You will be given a specific date for when the loan has to be repaid.
Among the most common entities that offer loans are major and local banks; programs affiliated with the Small Business Administration (SBA) and alternative lending companies, such as BFS Capital. While banks typically charge lower interest rates, the requirements can be difficult to meet, including little flexibility on credit scores and documentation reflecting several years of financial records. Alternative lender have more flexibility in making loans, but the interest rate will be higher.
Loans are considered the best way to fund amounts that will take a year or more to repay and for higher dollar amounts. For example, the SBA will consider loans up to $5 million. Another benefit with small business loans is that interest paid can often be deducted on your taxes.
What Is an Advance?
For the small business owner seeking an advance, the two most common types are cash and Merchant Cash Advances (MCA).
As with personal credit cards, you can take a cash advance on your business credit card. It can be an effective way to get funds quickly, and some credit cards offer a period with no interest. However, if you only pay the minimum amount, it can be very costly in terms of interest rates and other fees. Also the maximum dollar amount will often be less than a traditional loan.
MCAs are another type of advance that many small business owners have used. With this funding solution, the business receives an advance against future credit card sales, and money is then repaid from the business’ future credit card transactions.
Unlike a loan which consists of regular fixed payments, a set percentage out of a merchant’s daily credit card sales repays the advance until the full amount and premium are recovered. Small business owners who use this type of financing solution find it beneficial as the amount paid varies with their cash flow, so less is paid in slower sales periods. Also, these types of funding solutions can be much easier to get than a traditional loan, where lenders may have very strict criteria in loan decisions.
A number of alternative lending companies offer MCAs. However, be careful when selecting one. A good source to identify trustworthy companies is the Better Business Bureau (BBB). While some lenders such as BFS Capital have A+ ratings, many others have lower or no ratings.