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 is to secure a loan. But do you know how to choose the best one for your needs and objectives?
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The most common types of business 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. 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. Small Business Administration loans
The Small Business Administration (SBA) offers different types of loans specifically 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. These loans can be used for a variety of things, including working capital, to purchase real estate, acquire or expand, and even 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 smaller loan amounts and have shorter repayment terms. The average loan is $13,000, and the maximum repayment term is six years.
- CDC/504 loan program: The 504 loan program gives businesses a long-term fixed rate for major assets like real estate and equipment. The SBA generally provides 40% of the loan, while an approved lender covers as much as 50%. 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 destroyed in a declared disaster.
2. Traditional loans
SBA loans are great – if you qualify. However, traditional loans offer even more opportunities for people who don't meet the requirements or need something more flexible. Here are some different types of traditional loans.
- Equipment loan financing: 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 instead of 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 but not other months, a line of credit is perfect. It just sits there until you need it, and you can take out just the amount you need.
- Working capital loan: For many 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 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% of your anticipated volume. You then steadily repay it over the next month with specific terms.
- Invoice factoring: Invoice factoring is a unique way of increasing cash within your business by leveraging money that's already owed to your business. It works like this: You sell any outstanding invoices you have to a factoring company in return for a lump sum (usually 70% to 90% of the total amount). You're then able to use this cash as you see fit.
- Business credit cards: In some cases, a simple business credit card can be used as a line of credit to fund business purchases. However, much like personal credit cards, business credit must be used with extreme caution and discipline; otherwise, costs can get out of hand.
- Secured loans: A secured business loan is very much a traditional loan in the sense that it's backed by an asset, such as a
- Unsecured loans: An unsecured loan is the opposite of a secured loan in the sense that no collateral is required. This poses less risk for the business, but it also means you offset the risk in other ways – such as higher interest rates.
- Term loans: A term loan is a very basic type of loan that operates much like a student loan or home mortgage. The business borrows a lump sum upfront and is then required to repay it in weekly or monthly installments over a predetermined period of time.
- Personal loans: While it's not always the first option business owners pursue, personal loans can be used for business purchases and expenses (so long as the lender doesn't have restrictions that state otherwise). Personal loans are considered unsecured debt and are widely used for a variety of purposes.
|SBA 504 loan|
|SBA disaster loan|
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. Here are some recommendations for choosing the right loan for your situation.
1. Become more self-aware.
Before you do anything else, spend time evaluating your business and how lenders see you. A quick credit check will help you understand your score, which is an important factor, but you also need to know 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 said. "Therefore, the higher the debt-to-equity ratio, the less safe your business [is]."
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, how much time do you have to pay off the loan? 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 tiny 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 to apply, while others don't? Ask if any fees are associated with the application. 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.
5. Take your time.
You may feel like time isn't on your side, but it's OK to take things slowly. The absolute worst thing you can do is rush into this. Prematurely selecting a loan, only to figure out later that you chose the wrong one, can be devastating to your business. Be patient and carefully evaluate all of your options as you navigate the process.
What to consider before looking for a business loan
Business loans come in a variety of types, with varying repayment terms and fees. When shopping for a loan, it's always important to look at the annual percentage rate (APR). This tells you the total cost of the loan, including interest and fees. But that's not the only thing you should consider when selecting a small business loan. Here are some other important factors to keep in mind.
The interest you'll pay on your loan boils down mainly to your credit score. The lower it is, the more you will pay for a small business loan. If your credit score is in the mid to high 700s, you'll get a better interest rate than if it's in the low 600s. [Read related article: Business Financing Options for Every Credit Score]
Many lenders provide flexibility regarding when and how often you pay back your loan. The longer the terms, the smaller the payments are, but the more interest you'll pay. Conversely, the shorter the loan, the less interest you'll pay. It's important when selecting a small business loan to think about the monthly payment. You have to be able to afford it without dipping into savings or impacting cash flow. Terms can run from as short as three months to as long as 10 years.
Some lenders require you to offer personal or business collateral to back up the loan if you default. Known as collateral, it could include real estate, equipment, vehicles or other valuable assets. If you can't pay back your loan, the lender can collect your collateral. Make sure you understand the collateral requirements and risks before agreeing to the loan. For example, our review of SBG Funding found that it doesn't require collateral.
In lieu of collateral, some lenders require a personal guarantee. That means the lender can come after your personal assets if your business defaults on the loan. Many lenders require a personal guarantee in addition to collateral.
Time to deposit
Depending on the lender you work with, you can have the money in your bank account the same day, within two to three business days or, in the SBA's case, in a few weeks. Applying for a bank or SBA loan may not make the most sense if you need the money fast. We found through our research that Rapid Finance stands out as a fast-funding lender. Learn more in our Rapid Finance review.
Larry Alton contributed to the writing and research in this article.