Types of Business Loans and How to Choose

How to choose a business loan

Take the following steps to help ensure you pursue and apply for the most suitable loan for your situation.

1. Understand your credit score and debt-to-equity ratio.

Before pursuing lenders or taking steps toward funding, get a clear picture of how lenders see you by knowing your credit score and debt-to-equity ratio.

• Credit score: Your credit score may affect the interest you pay on a loan. If it’s in the mid to high 700s, you’ll get a better interest rate than if it’s in the low 600s. [Read related article: When Does Your Business Credit Score Matter?]
• Debt-to-equity ratio: According to business consultant and author David Duryee, your debt-to-equity ratio 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,” Duryee explained. “Therefore, the higher the debt-to-equity ratio, the less safe your business [is].”

2. Determine your funding needs.

Assess your funding needs before applying for a loan. If you borrow too little, you won’t cover your startup costs and may incur additional fees to increase your loan amount. If you borrow too much, you’ll pay interest on a higher-than-necessary principal.

First, consider why you’re borrowing money. You may be taking out a loan to pay for startup expenses or cover other financial needs, such as the following:

• Are you borrowing money to cover a shortfall in revenue? If so, determine a realistic amount and increase it by at least 10 percent. You’ll be covered if things are worse than your projections.
• Do you need money for a one-time expense? If you need money to buy new equipment or build cash reserves, borrow only the amount you need.
• Are you borrowing money for growth-oriented expenditures? If you’re taking a loan to open a new business location or pursue another growth venture, factor in the venture’s projected revenue and create a timeline. If your venture will generate revenue in the short term, you might get by with a smaller loan. However, longer timelines will require a larger loan amount.

3. Research lenders.

After determining how much money you need, it’s time to research lenders. Talk to colleagues and industry peers, and visit review sites for recommendations and advice. 

When researching lenders, assess the following critical factors:

• Loan amount limits: Some lenders impose minimum and maximum loan amounts. Ensure any lender you consider will accommodate your loan needs.
• Ease of approval: Lenders have various approval criteria. For example, if you need a high-risk business loan because your industry is considered precarious, find a lender that works with businesses in your industry. Other factors that may affect the approval process include years in business and credit score requirements.
• Reputation: Research lenders’ customer service reviews to get a feel for what it’s like to work with them. 

4. Consider the interest rate and APR.

While the interest rate shouldn’t be a deciding factor, you must consider it. For example, if a $100,000 loan has repayment terms of five years, a difference of two percentage points may not matter much. However, if the loan were for $1 million spread out over 20 years, those percentage points would be significant. 

It’s also important to look at the annual percentage rate (APR). This tells you the total cost of the loan, including interest and fees.

5. Look at repayment terms.

As noted above, business loan repayment terms are a crucial consideration. Determine how much time you have to pay off the loan. Terms can run from as short as three months to as long as 10 years. What does the payment schedule look like? Can you pay off the loan early, or do you have to wait until maturation? While these details may seem insignificant, they can save or cost you tens of thousands of dollars.

Next, assess how much you can afford in loan payments. Calculate monthly payment amounts for various loans and see how these payments fit into your overall budget. The longer the repayment terms, the smaller your payments will be, but the more interest you’ll pay. Conversely, the shorter the loan, the less interest you’ll pay. You must be able to afford your loan payments without dipping into savings or impacting cash flow. 

6. Understand collateral or personal guarantee requirements. 

Some lenders require you to offer personal or business collateral to back up the loan if you default. Others require a personal guarantee. 

• Collateral: Collateral can include real estate, equipment, vehicles or other valuable assets. If you can’t repay your loan, the lender can collect your collateral. Ensure you understand the collateral requirements and risks before agreeing to a loan. Not all lenders require collateral. For example, in our review of SBG Funding, we explain that this lender operates without requiring collateral.
• Personal guarantee: Some lenders require a personal guarantee. That means the lender can come after your personal assets if your business defaults on the loan. Some lenders even require a personal guarantee in addition to collateral. 

7. Consider application fees.

Some lenders impose application fees, while others don’t. Ask any potential lender if fees are associated with the application. Additionally, determine if the lender charges fees for items tied to the application process, such as the cost of running your credit report or getting your collateral appraised. 

8. Compare loans.

For each lender you’re considering, evaluate all factors, including costs (interest rate, upfront fees, penalty fees), terms (length of the loan, ability to repay early, lump sum versus line of credit), and collateral or personal guarantee requirements. Calculate the loan’s projected cost over the repayment term to more accurately compare loan options. 

Next, eliminate the most expensive options and compare terms for the remaining lenders. 

9. Take your time when choosing a loan. 

It’s OK to take things slowly. Rushing into a loan is ill-advised. Prematurely selecting a loan, only to realize later that you chose the wrong one, can devastate your business. Be patient and carefully evaluate all your options as you navigate the process.

10. Apply for a business loan.

After thoroughly assessing potential lenders and loan options, it’s time to apply for a business loan with your top choice. If its terms are acceptable, complete the process. Otherwise, apply to your second choice.

The most common types of business loans

Various types of business loans exist. Two of the most common categories are Small Business Administration (SBA) loans and traditional loans. 

1. Small Business Administration loans

There are several SBA loan options, including the following: 

• 7(a) loan program: The 7(a) loan is the SBA’s most basic and popular option. These loans can be used for various purposes, including working capital, real estate purchases, business acquisition and expansion, and even refinancing existing debt.
• Microloan program: The SBA offers microloans for new or growing businesses. Businesses can use microloans for many of the same purposes as 7(a) loans. However, as the name implies, microloans are small business loans with 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 percent of the loan, while an approved lender covers as much as 50 percent. The borrower must put up the remaining percentage. The maximum 504 loan is $5.5 million; details are negotiable to include 10- or 20-year maturity terms.
• Disaster loans: SBA disaster loans max out at $2 million and 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 borrowers who don’t meet the requirements or need something more flexible. Traditional loans include the following:

• Equipment loan financing: Some small businesses need a loan to purchase necessary equipment. An equipment loan allows you to purchase anything from tablets for your employees to new machinery in the warehouse. You’ll make monthly payments instead of paying cash upfront.
• Line of credit: Some businesses have unpredictable sales and need cash at various times. In this situation, a line of credit is perfect. It’s there if and when you need it, and you borrow only what you need.
• Working capital loan: For many small businesses, revenue is cyclical, meaning some months are lean. A working capital loan is a short-term solution that temporarily infuses cash into your business while you find ways to generate more revenue.
• Merchant cash advance: If you run a small business with many 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 percent of your anticipated volume.
• Invoice factoring: Invoice factoring is a unique way to boost cash flow by leveraging money you’re owed. You sell outstanding invoices to a factoring company in return for a lump sum (usually 70 to 90 percent of the total amount). You can use this cash as you see fit.
• Business credit cards: In some cases, a business credit card can serve as a line of credit to fund business purchases. However, like personal credit cards, business credit must be used with extreme caution and discipline; otherwise, costs can get out of hand.
• Secured loans: Secured business loans are backed by assets, such as property or vehicles. The lender can take the collateral if you fail to repay the loan.
• Unsecured loans: Unsecured loans don’t require collateral, so there’s less risk for the business; however, the business must often offset the risk in other ways, such as higher interest rates.
• Term loans: A term loan is a basic loan that operates much like a student loan or home mortgage. The business borrows a lump sum upfront and must repay it in weekly or monthly installments over a predetermined period.
• Personal loans: While they’re not always the first option business owners pursue, personal loans can be used for business purchases and expenses (as long as the lender doesn’t have restrictions that state otherwise). They are considered unsecured debt and are widely used for various purposes.

Best business loan providers

We’ve evaluated many of the best business loans and financing options to help small businesses choose the best lending option for their situation. The following lenders stand out as excellent options: 

BusinessLoans.com

BusinessLoans.com is a one-stop shop that can save businesses time as they shop for loans. Instead of applying with individual lenders, you can fill out a single application on this platform, and it will match your needs to multiple lenders in its network. BusinessLoans.com can help you identify lenders you might not otherwise have considered. Our review of BusinessLoans.com details its easy application process and favorable terms. 

Fundbox

Fundbox can help you with traditional term loans and short-term lines of credit. Lines of credit can help you limit your accrued interest because you borrow funds only when you need them. Its navigable interface helps you stay on top of your loan while maximizing cash flow. Our Fundbox review explains how the platform will integrate with the best accounting software solutions to reduce manual data entry. 

Noble Funding

Noble Funding goes above and beyond to make the lending process easier for its clients. Offering various loan products, including term loans up to $500,000 and short-term bridge loans up to $2 million, the company works with you to create an initial cost estimate so you can tell right away if it’s a viable option. Our Noble Funding review explains that this lender has no prepayment penalties and doesn’t require collateral. 

Jennifer Dublino contributed to this article. Source interviews were conducted for a previous version of this article.