Many small businesses require loans to start out or scale up, but the process of applying for a small business loan can be confusing. Submitting a loan application can be an intimidating process because it requires you to give a bank or credit union significant information on your business's financial performance and projections.
Fear not! Landing a small business loan doesn't have to be difficult. It just takes a little knowledge to navigate the application process and best position your business for lender approval. This guide will walk you through the process of securing a small business loan from start to finish. We'll also introduce you to the concept of alternative lending, which might be useful for businesses unable to qualify for a conventional small business loan.
A small business loan is a type of financing provided to an entrepreneur for the express purpose of opening or growing a small business. This includes term loans from banks and credit unions. Depending on the lender, small business loans could range in value from a few hundred dollars to several million.
Small business loans are generally among the more affordable types of funding. Depending on the lender's requirements and the borrower's circumstances, the interest rates for small business loans generally range from 2% to 8%.
What is the most common type of small business loan?
One common type of small business loan is the U.S. Small Business Administration (SBA) 7(a) loan. The SBA administers this program through banks, which are the actual lenders, but the SBA guarantees the loan. This reduces risk for the lending institution if the borrower defaults. The reduced risk lowers costs and opens up approval to a wider swath of candidates. SBA 7(a) loans range in value from $500 to $5.5 million.
How do you repay a small business loan?
Most small business loans are structured in a familiar way. The lender provides a principal amount, which is paid back with interest over a predetermined amount of time. For example, if a bank gives a business a one-year loan of $10,000 with an annual percentage rate (APR) of 10%, the borrower usually pays back the loan plus interest in 12 monthly installments. In this case, the monthly payment would be about $880. When the loan is fully repaid, the borrower will have paid the lender the principal amount of $10,000 plus $550 in interest payments.
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If all that sounds good, you might be ready to apply for small business lending. Before you rush off to the bank and fill out the paperwork, though, take some time to organize your documentation and consider what the lender will want to see. Taking these steps prior to filling out your loan application will improve your chances of approval.
How to apply for a business loan in 7 steps
Every lender is different, but these are the common factors that influence a loan application – with a look at why they matter.
1. Prepare documentation.
"Applying for a conventional small business loan can be challenging," said Rob Misheloff, founder of Smarter Finance USA. "Many providers (particularly banks and SBA lenders) don't specify their requirements for qualification. Consequently, many small business owners spend hours preparing documents for conventional loans only to be denied, which can be a daunting and frustrating process."
Misheloff recommends preparing the following documents before applying for a loan:
- Two to three years of financial statements and/or tax returns
- Accounts receivables reports
- A minimum of three months' worth of bank statements
- A business plan
- Proof of ownership
2. Review your credit score.
For an unsecured business loan, a lender will examine your personal finances, including your credit history. In this case, you will be the individual guaranteeing the small business loan, so your personal finances matter to lenders.
"Maintain a good personal credit score," said Rob Stephens, founder of CFO Perspective. "Banks will require a personal guarantee on the debt, so good personal finances improve the odds of getting a loan."
3. Gather financial documents.
If your business is already established, your cash flow is an important consideration for a lender. They will examine your sales, revenue and expenses to determine whether you will have sufficient liquid capital each month to meet your repayment obligations.
"You need to gather cash flow statements for at least the last year," said Jesse Silkoff, founder of MyRoofingPal. "Have them looked at by a professional so you can make sure everything is in order."
You should also prepare other financial statements such as your balance sheet and income statement. Lenders will use your balance sheet to decide whether your assets, liabilities and shareholder equity make you likely or unlikely to repay your loan. Your income statement will show lenders your profits or losses during a quarter or year, further attesting to whether or not you'll be a low-risk borrower.
Your cash flow, balance sheet and income statements aren't the only things that might concern a lender. The debt-to-income ratio shows how much you've leveraged your business already. If you have a significant amount of debt on the books, it will be harder to secure another loan. Usually, lenders prefer to see less than a 30% debt-to-income ratio when issuing a new small business loan.
4. Create a business plan.
Before you receive a small business loan, the lender will likely want to know your plans for the money. After all, their interest is now dependent on your continued business success. Bring a detailed business plan to your lender to help convince them you're a safe bet.
"Once you have your documentation and reports assembled, you need to write up a business plan," Silkoff said. "Keep in mind the goal here is to show your company is financially stable and to define a use for the funds you hope to receive."
A business plan is critical, Stephens added, especially when you don't have a sufficient history of strong cash flow to persuade a lender. "Be ready to show a history of steady, strong cash flow, or a business plan with a strong likelihood of sufficient cash flow to repay the debt."
5. Consider your collateral.
Sometimes a lender will require you to put up collateral to guarantee a loan. Collateral is some asset of value that a lender can fall back on if you default. For example, when you take out a mortgage to buy real estate, that real estate becomes the collateral. Foreclosure occurs when a borrower defaults on a mortgage and the lender claims the property as recompense.
6. Consider which loan to apply for.
Earlier, we mentioned that SBA 7(a) loans are the most common type of small business loan. That doesn't make them your only option. You can also pursue business lines of credit, microloans, short-term loans and equipment financing. We'll explain these types of loans – and how your application process may differ based on the loan type – in more depth later in this guide.
7. Assemble and submit your application.
Prepare all your verification documents ahead of time. This includes tax returns, cash flow statements and bank statements. Depending on the size of your business and the type of loan you apply for, you may need to provide these documents for your business and your personal finances.
Once you've applied for a loan and submitted all the necessary documents, the ball is in the lender's court. They'll review your documentation and determine whether you should be approved or denied for the loan.
How long does it take to get approved for a small business loan?
Loan approval can take a few weeks or a few months, depending on the lender and specific type of small business loan. SBA 7(a) loans, for example, can take up to 90 days to approve. A small business bank loan, on the other hand, could be approved in as little as two weeks.
If you need funding tomorrow, a small business loan won't cut it. Small business loans are intended for starting or growing a business, not providing working capital. If you need money quickly to keep the lights on and the employees working, consider alternative lending options like a merchant cash advance or invoice factoring. These options are much more expensive than a small business loan, but they can provide funding in as little as 24 hours.
What repayment terms can you get for your small business loan?
While small business loans vary by specific type and lender, they tend to have several things in common. These are some of the elements of a small business loan you are likely to see regardless of the lender you approach:
- Short terms: Small business loans tend to be short-term loans, with many ranging from three to five years. However, some small business loans carry up to a 10-year term. It's also not unheard of for SBA 7(a) loans to come with a 25-year term, but these circumstances are less common.
- Fixed interest rate: Most small business loans have a fixed interest rate. This means the APR the lender quotes to you will remain the same over the life of the loan if you are approved. A fixed interest rate makes repayment easier than with a variable interest rate, which can fluctuate with the market.
- Value: While small business loans can reach the multimillions in value, most range from $10,000 to $500,000. These loans are commonly used to start or expand a business, such as buying inventory and equipment, securing a location, and so on.
There are also repayment terms beyond the structure of the loan to look out for, Misheloff said. Two big ones are blanket liens and covenants.
"[Blanket liens are] a lien on every asset owned by the business," Misheloff said. "Blanket liens can restrict further borrowing capabilities because they can restrict another lender's ability to repossess assets or otherwise seek remediation of a loan gone bad.
"Loan covenants may stipulate that certain ratios (i.e., debt to assets or profitability ratios) must remain within a certain range," he added. "If the ratios fall below a certain number, the loan may become due and payable immediately."
Understanding the repayment terms of a loan, from the structure to individual clauses in the deal you sign, is critical to successfully paying it back. If possible, have an attorney review the terms of a loan alongside you before you sign. [Read related article: Hidden Gotchas in Your Business Loan Repayment Terms]
Types of small business loans to consider
Below are several types of small business loans that might fit your company's needs. Learn more about these loan types on our business loan best picks page.
Secured vs. unsecured loans
A secured loan means there is an asset the lender can seize if you default on the loan. This is known as collateral. Property and equipment loans often use the asset you are buying as collateral. Other types of loans may require you to put up business or personal assets as a form of collateral. Unsecured loans require no collateral. If you default on the loan, the lender's only recourse is to sue you for the balance owed.
Business line of credit
A business line of credit offers you flexibility. You'll have access to credit when you need it, and pay interest only on what you actually borrow. This type of credit is revolving, allowing you to pay down the balance and then take out money when you need it.
Unlike government loans, private companies administer business lines of credit. Our top recommendation for business credit line companies is Fundbox. It keeps the process transparent and simple, offering up to $150,000 in credit with terms spanning three to six months. You'll also receive your funding quickly after you apply. Learn more about why Fundbox might be right for you in our Fundbox business line of credit review.
SBA loans are often a slower process, but they can provide you with a larger loan amount. The application process can take a few months. There is an express loan option, but it will still take a few weeks to a month for your funds to arrive after approval. The SBA says that loan amounts range from $500 to $5.5 million.
According to Investopedia, microloans are usually peer to peer. This means one individual will lend money to another individual. One person may finance the entire loan, or many investors may lend a small portion of the overall loan.
Microloans carry a higher interest rate because they are considered higher-risk loans. They are normally unsecured. They are a good option for those who don't qualify for other types of loans and those who need a small amount of money quickly.
If microloans sound right for you, we recommend getting yours through Accion. The company's microloans can be as low as $500 or as high as $150,000. It specializes in working with small business owners who have low credit scores or belong to marginalized groups (or both). Learn more about its offerings in our Accion microloan review.
Short-term loans can give you the cash you need in as little as 24 hours. The terms are generally one to three years. If you need a loan and know you can pay it back quickly, they are a good option.
According to Lendio, merchant loans carry a higher interest rate, as much as 18%. However, the requirements are less stringent than most types of loans. After you receive the loan, a percentage of your daily deposits are transferred to the lender.
Equipment loans have lower requirements as well, because the equipment serves as collateral. Equipment loans can be used for any type of equipment that's necessary for your business. A new laptop, manufacturing equipment and a commercial printer are a few examples.
Traditional vs. alternative lenders
In addition to different types of loans, there are different types of lenders. Traditional lenders are banks and other traditional financial institutions. Alternative lenders generally have lower approval requirements and a more straightforward or flat-fee structure.
Traditional bank loans charge monthly interest based on your current balance. Alternative lenders often charge a flat interest fee with no penalty for paying off the loan early. They usually have daily or weekly payments instead of the monthly payments that are standard for bank loans.
What are common mistakes to avoid when applying for a business loan?
Once you're approved, it might be appealing to grab the money and run, but take a breath and think things through first. Make sure you avoid the most common mistakes small business owners make when accepting a small business loan.
Borrowing too much money
This might seem obvious, but borrowing money means you'll have to pay it back with interest. If you don't have the ability to repay your loan, you're going to default. That means hard-to-repair damage to your credit score and the loss of any collateral you put up to secure the loan. If you personally guaranteed the loan, a default would also damage your personal credit score and put your own assets on the line, including your home.
"Small businesses shouldn't borrow more than they can afford to pay back," Misheloff said.
The moment you are approved for a loan, you should examine the terms and craft a repayment strategy. Debt is a useful tool for an entrepreneur, but failure to plan for how you'll repay that debt could start a vicious cycle of taking out more loans to cover your existing debts.
Failing to maintain strict documentation
Strict documentation, both of the loan agreement and your business's financial performance, can help you satisfy the terms of a loan with ease.
"Get a copy of the loan documents before you sign them, and actually read them," Stephens said. "If you don't want to read them, pay a CPA or attorney to read them."
Stephens also recommends keeping a detailed cash flow projection to identify when your cash might be low ahead of time. That way, you can prepare to find additional liquid capital to service your debt, rather than be taken by surprise.
Triggering defaults by accident
Defaults are often associated with missed payments, but other issues could lead to default, depending on the terms of the loan.
"Realize that loan default can be triggered by many things other than missing payments," Stephens said. "It may be caused by failing to comply with any terms of the agreement, a false statement by the borrower at any point to the lender, or a material adverse change in the borrower's financial condition."
Avoid triggering defaults by always paying on time and thoroughly understanding all the repayment terms of the loan. If you maintain strict documentation, you can periodically review the terms of the loan to ensure you remain compliant.
Can you qualify for a small business loan with bad credit?
Typically, small business lenders look for borrowers with a credit score that's at least in the mid-600 range. Some lenders are more willing to work with low credit scores than others, though, so shop around before giving up.
"Local banks can sometimes be more forgiving and offer more favorable rates," Silkoff said.
However, if even local banks won't look twice at your application because of a bad credit score, there are other loan options for businesses with bad credit. Generally, these are provided by private companies known as alternative lenders or online lenders. They tend to be more expensive, but they're also more flexible in how the loan can be used, and the loans tend to be approved more quickly than conventional small business loans.
Borrowing responsibly can grow a business
Taking on debt isn't necessarily a bad thing. It can help you grow your business and position yourself for future success that would not be possible otherwise. However, irresponsible borrowing puts a business at risk of financial ruin. If you're considering taking out a small business loan, consult with a professional accountant first.
It's also wise to have an attorney review any loan documents before you sign them. Finally, when accepting a loan, have a clear strategy to pay back the lender. If you keep those aspects of borrowing in mind, you should be able to make a small business loan work for you.
Max Freedman contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.