Having a good idea plays an important role in being a successful entrepreneur and small business owner, but it's not the only requirement. Unless you have the means to self-fund, the first step will be to secure a loan. But do you know how to choose the best one for your needs and objectives?
Most common types of loans
If you don't have any experience in the world of financing, then you probably don't realize that there are many different types of loans. In fact, there are enough different loan types and formats to make your head spin. So before we dig into some tips and tricks for evaluating and choosing the right loan, let's take a brief look at two of the most common types of loans, as well as the individual funding options within each category.
1. SBA loans
The Small Business Administration offers different types of loans specifically designed for small business owners who meet certain requirements and qualifications. Here are the four major types:
- 7(a) Loan Program. By far the most basic and popular loan the SBA offers is the 7(a) Loan Program. These loans can be used for a variety of things, including as working capital, to purchase real estate, to acquire or expand, and even to refinance existing debt.
- Microloan Program. For brand-new or growing businesses, the SBA offers small loans in the form of microloans. These loans can be used for many of the same things a 7(a) loan can be used for; they just come in a smaller amount and shorter repayment terms. The average loan is $13,000, and the maximum repayment term is six years.
- CDC/504 Loan Program. This loan program gives businesses a long-term fixed rate for major assets like real estate and equipment. The SBA generally provides 40 percent of the loan, while an approved lender comes in and covers as much as 50 percent. The borrower then has to put up the remaining percentage. The maximum 504 loan is $5.5 million, and details are negotiable to include 10- or 20-year maturity terms.
- Disaster loans. Finally, there are SBA disaster loans. These loans – which max out at $2 million – can be used to purchase, repair or replace assets that were destroyed as part of a declared disaster.
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2. Traditional loans
SBA loans are great … if you qualify. However, for people who don't meet the requirements or need something more flexible, traditional loans offer even more opportunities. Here are some different types of traditional loans:
- Equipment loan. A lot of small businesses simply need a loan for equipment. With an equipment loan, you can purchase anything from tablets for your employees to new machinery in the warehouse and make monthly payments on the items, as opposed to having to fork over all of the cash at once.
- Line of credit. If your business is more unpredictable and you need cash some months and don't need any other months, a line of credit is perfect. It just sits there until you have a use for it, and you only have to take out the amount that you need.
- Working capital loan. For lots of small businesses, the cyclical nature of revenue means there are some months when there isn't enough money to keep the lights on. A working capital loan is a short-term solution that enables you to temporarily infuse cash into your business while you find ways to bring in more revenue.
- Merchant cash advance. If you run a small business where you get lots of credit card transactions, a merchant cash advance can help you keep money flowing. This type of loan is based on the volume of your monthly transactions and gives you an advance of up to 125 percent of your anticipated volume. You then steadily repay it over the next month with specific terms.
4 tips for evaluating and choosing the right loan
Is your head spinning yet? Those were just a few examples of small business loans – many more exist. To help you avoid becoming a victim of information overload, here are some tips for evaluating and choosing the right loan for your situation:
1. Become more self-aware.
Before you do anything else, you have to spend a little time evaluating your business and how lenders see you. A quick credit check will help you understand your score, which is one factor involved – but you also need to look at your debt-to-equity ratio.
According to business consultant David Duryee, this is one of the most important metrics a lender analyzes. "It is a basic financial principle that the more you rely on debt versus equity to finance your business, the more risk you face," he explains. "Therefore, the higher the debt-to-equity ratio, the less safe your business."
2. Consider the interest rate.
You obviously want to consider the interest rate, though this shouldn't be the only determining factor. For example, if a $100,000 loan has repayment terms of five years, a difference of two percentage points really doesn't matter that much in the grand scheme of things. It would, however, matter if the loan were for $1 million spread out over 20 years. Be smart about comparing interest rates, and give more weight to it when terms are higher.
3. Look at repayment terms.
Speaking of repayment terms, what is the length of time? What does the payment schedule look like? Can you pay off the loan early, or do you have to wait until maturation? It's easy for these to seem like small little details in the fine print of a loan, but they can save or cost you tens of thousands of dollars when it's all said and done.
4. Consider application fees.
Are you aware that some lenders actually require you to pay in order to submit an application, while others don't?
"It is important to ask what types of fees are associated with the application," Business News Daily advises. "Some lenders charge an application fee, while others charge fees for items tied into the application, such as the cost to run your credit report or get your collateral appraised."
Take your time
You may feel like you have time against you, but it's OK to slow down a bit. The absolute worst thing you can do is rush into this. Prematurely selecting a loan, only to figure out a month from now that you chose the wrong one, can be devastating to your business. Be patient and carefully evaluate all of your options before proceeding too far in the process.
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