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Everything You Need to Know About Installment Loans

Donna Fuscaldo
Donna Fuscaldo
Senior Finance Writer

Installment loans are a viable funding option for many small businesses. Before you take one out, check out our guide.

In this era of fast and short financing, it's understandable that small business owners may overlook installment loans. After all, they require more documentation than some of the other types of lending products in the marketplace.

But this type of loan – in which you get a lump sum you repay over a predetermined amount of time – gives you predictability and a fixed interest rate, which could prove advantageous as you grow your enterprise.

"I like installment loans because, with other loan products out there, the payment may vary and it's unclear what the APR is," Joseph Meuse, founder and president of Business GPS, told business.com. "A lot of business owners know how to deliver a product or service, but they aren't a CFO. The loan product is easy for them to understand and budget for."

 

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How do business installment loans work?

Business installment loans work like a mortgage or car loan: You borrow a lump sum of money and must pay it off over 12, 24, 36, 48, or 60 months, sometimes longer. The interest rate you pay on the loan is fixed and is dictated by your credit score. The cost for funding is much lower for borrowers with high credit scores than for those who have bad credit. Installment loans can be used to purchase equipment or property, for working capital, or to consolidate debt, among other things.

Whether an installment loan is the best funding product for your business depends on why you need the cash.

"You don't want to take a debt obligation for too long to provide a solution for a cash need that may be short," said Josh Jones, chief revenue officer at Kapitus. "Knowing your needs is super important."

What are the types of business installment loans?

Small business installment loans can be used to purchase a vehicle or piece of business equipment, to acquire property, or to pay down expensive debt. They come in different terms, depending on your business needs.

  • Long-term loans: These loans have terms of six years or longer. They are typically used for big purchases such as a company vehicle or property.
  • Medium-term loans: These loans have terms from two to five years and are commonly used to purchase business equipment or to fund expansion.
  • Short-term loans: These loans have terms of less than two years. They are typically used to purchase inventory, to fill gaps in cash flow, for working capital, or for other short-term cash needs.

The longer the term of the installment loan, the more interest you'll pay and the harder it is to get approved. Lenders are taking a bigger risk when they commit to you for six years rather than 18 months, so they charge more.

"Whether you are using it for a vehicle, a piece of equipment, or mortgage, make sure you're using the cash for something you purchased over the course of the payback term," Jones said. "If you're not using the money over the payback terms, an installment loan may not make sense."

What do you need to apply for a business installment loan?

A small business installment loan isn't as easy to get as other financing options. Banks, credit unions, and alternative lenders all offer installment loans but expect a higher credit score and greater business strength than they do for other financing types. That's particularly true during the COVID-19 pandemic, with lenders being even more risk-averse. That means you'll need a good credit score, a sound business, and the willingness to offer up collateral.

"If you have assets, equipment, real estate, or accounts receivable you can use as collateral, an installment loan is for you," Meuse said. "There's more documentation required these days, sometimes a little bit higher credit score, and sometimes loans-to-value [ratios] are less, but lenders have a good appetite."

From your credit score to business bank account statements, here's what applying for an installment loan entails.

Credit score

Lenders are risk-averse, so your chances of getting a low-interest installment loan depend largely on your proven ability to pay it back. That's where your business and personal credit score come in. Unless your company has been in business for years and has solid revenue growth, lenders will look at your personal credit score to assess your creditworthiness. If your credit score is low, they will either deny your loan application or charge you a higher interest rate. Banks and credit unions typically have higher credit score requirements than alternative lenders. Some lenders cater to business owners with poor credit.

Collateral

Business installment loans are typically secured, which means you must put up collateral. Collateral can be an asset such as equipment, accounts receivable, or property, which the lender gets if you default on the loan.

Personal guarantee

Unless you run an established business with years of revenue growth, lenders will require more than collateral; they'll want a personal guarantee from you. This is a legally binding statement that you will pay back the loan personally if your business can't.

Business plan

To approve you for a loan, lenders will want to know about your business. That's where the business plan comes in. You want to have a compelling story, laid out in a slide deck or on paper, that shows your plans and your pathways to growth. It should be clear, concise, and detailed, showing lenders a sound business idea. The plan should include how much money you need and why, how you'll pay back the loan, and the assets you're willing to put up as collateral.

Business and personal documentation

Lenders require a lot of documentation about your business and personal finances to approve your loan application. Banks and credit unions require more paperwork than alternative lenders, but either way, it's important to have it all ready before you apply. Each lender has its own twist on documentation, but these are the most common requirements:

  • Bank statements
  • Tax returns
  • Business plan
  • Proof of business ownership
  • Personal information

What are some tips for shopping for a small business loan?

Installment loans are a viable option for small business owners if they shop smart and choose the best lender for them. You don't want to be stuck with a high-interest loan and a lot of hidden fees. That's why Libby Morris, vice president of operations at Funding Circle US, said it's important to pay attention to all the costs associated with an installment loan.

"One of the things we look for as part of our responsible lending is, are they disclosing all their fees?" Morris said. "Small business lending is not as highly regulated as consumer lending. You may see a good rate and there's all these hidden fees." Morris said to avoid lenders that charge you a prepayment penalty for paying your loan back early.

When you apply for an installment loan, Morris said, be prepared for a counteroffer from your lender, particularly in the current environment. With the coronavirus still out of control, lenders are wary about taking on too much risk. They have an appetite for lending but may not want to be as generous as you hope. Morris said it's not surprising for a business owner to apply for $500,000 and get approved for $300,000.

"You have to be flexible in how much you really need," she said.

Image Credit: Kerkez / Getty Images
Donna Fuscaldo
Donna Fuscaldo
business.com Staff
Donna Fuscaldo is a senior finance writer at business.com and has more than two decades of experience writing about business borrowing, funding, and investing for publications including the Wall Street Journal, Dow Jones Newswires, Bankrate, Investopedia, Motley Fool, and Foxbusiness.com. Most recently she was a senior contributor at Forbes covering the intersection of money and technology before joining business.com. Donna has carved out a name for herself in the finance and small business markets, writing hundreds of business articles offering advice, insightful analysis, and groundbreaking coverage. Her areas of focus at business.com include business loans, accounting, and retirement benefits.