Small businesses account for nearly half of the private workforce in the United States, generating two out of every three new jobs. For small business owners, obtaining a business loan can be crucial for starting or expanding a business, purchasing essential equipment, or covering working capital needs. Understanding how business loans operate can help you choose the right loan and use it effectively as a vital resource.

Understanding Business Loans

A small business loan is a form of commercial financing available from traditional banks, credit unions, and online lenders. These funds can be used to cover various business expenses, such as working capital, equipment purchases, and even larger investments like real estate.

Business loans offer financing to business owners either as a lump-sum payment or a credit line. In return, your business agrees to repay the borrowed amount over time, along with interest and any applicable fees. Depending on the loan type, repayments may be required on a daily, weekly, or monthly basis until the loan is fully paid off.

Business loans can be either secured or unsecured. Secured loans require collateral, such as real estate, equipment, cash, or investments, which the lender can repossess if you fail to repay the loan. Unsecured loans do not require collateral but typically require a personal guarantee, making you personally liable if the business does not repay the debt as agreed.

Common Uses for Business Loans

Business loans can be used for a variety of purposes, and when applying for financing, you’ll typically need to specify how you plan to use the funds. Common uses for business loans include:

• Initial startup expenses
• Buying or remodeling commercial real estate
• Working capital for daily operations
• Consolidating or refinancing existing debt
• Purchasing equipment
• Buying inventory
• Acquiring businesses
• Expanding your business
• Franchising your business
• Marketing and promotional activities

One important type of expense not included in the list above is personal expenses. Generally, lenders do not permit the use of business loans for personal costs, such as buying a home, personal vehicles, or other non-business-related transactions.

Types of Business Loans

Here are seven types of business loans to consider if you need funding for your company. Working with a business loan broker can be a helpful way to find the best option for your needs.

Term Loan

Business term loans are a popular form of financing that are repaid over a fixed period. You can obtain a business term loan from traditional banks or online lenders. Newer businesses often find better approval chances with online lenders, as they usually have more flexible qualification criteria compared to traditional banks.

These loans usually have terms of up to 10 years, with loan amounts reaching up to approximately $500,000. Annual percentage rates (APRs) typically start around 9%. The terms offered to your business depend on factors such as your business’s credit score, annual revenue, and overall creditworthiness, including your personal credit.

SBA Loan

An SBA loan is a form of financing supported by the U.S. Small Business Administration (SBA), which guarantees a portion of the loan amount. This guarantee reduces the lender’s risk, making them more likely to approve loans for businesses that might not qualify for traditional financing.

SBA loans can offer competitive rates for qualified borrowers.These loans typically range from $30,000 to $5 million and offer extended repayment terms of up to 25 years. However, the qualification process for SBA loans can be quite rigorous. Be prepared for a complex application process and a potential wait of several months to determine your eligibility. A personal credit score of at least 680 is generally recommended for these loans.

Business Line of Credit

A business line of credit provides flexible borrowing, allowing you to access funds as needed without specifying the exact amount upfront. You can draw between $2,000 and $250,000, similar to how you use a credit card. You can reuse your credit limit as you repay it during the draw period, and you’ll only pay interest on the amount you actually borrow, not the entire approved limit.

Unlike business credit cards, a business line of credit has a draw period that eventually expires, usually within 12 to 24 months. After the draw period ends, the repayment period begins, during which you’ll need to repay any outstanding balances plus interest. This repayment period can last from six months to five years, and during this time, you won’t be able to access your credit limit for additional borrowing.

Merchant Cash Advance

A merchant cash advance offers a quick way to access short-term financing when your business needs immediate funds. In an MCA, business owners provide the lender—often a merchant services company—with a portion of future sales receipts in exchange for a lump sum of cash. This amount, plus fees, is repaid through a percentage of daily or weekly sales or via automatic clearing house (ACH) payments.

However, while the loan process for MCAs is streamlined and qualification criteria are less stringent, they can be costly. MCAs charge a factor rate between 1.2 and 1.5. For instance, if you receive an MCA of $10,000 with a factor rate of 1.2, you would need to repay a total of $12,000.

MCAs can be a good choice for businesses with high sales volumes that require quick cash and may not qualify for a traditional business loan.

Equipment Financing

Equipment financing can assist your business in purchasing necessary equipment, ranging from small items like electronics to large machinery. Loan amounts generally depend on the cost of the equipment, with lenders typically financing between 80% and 100% of the equipment’s cost. A down payment of around 15% is often required. Terms for equipment financing range from three to 10 years, and the equipment purchased often serves as collateral.

Invoice Factoring

Businesses that use an invoicing system to bill other companies might qualify for invoice factoring. In this financing method, your business sells its outstanding invoices to a factoring company. The company then advances you a percentage of the invoice amounts (typically 70% to 100%) and takes over the responsibility of collecting the payments.

Once the factoring company collects the payments, they pay your business the remaining balance of the invoices minus the factoring fees. These fees generally range from 0.50% to 5% per month for each invoice that remains unpaid. Invoice factoring is especially beneficial for startups and new businesses that may not have a robust credit profile yet.

Requirements for Business Loans

Business loan requirements can vary based on the lender and the intended use of the funds. The type of loan you are applying for also affects the qualification criteria. However, you can generally expect the following requirements:

• Business and Personal Credit Score: Lenders usually review both your business and personal credit scores. The minimum score required varies depending on the type of loan. For instance, you generally need a minimum score of 680 for a traditional bank loan or an SBA loan, and around 630 for business lines of credit or equipment financing. Strong business credit is also recommended to secure the most competitive interest rates.
• Annual Business Revenue: Some lenders may require a minimum amount of annual business revenue to qualify for financing. This requirement helps demonstrate that your business has the financial capacity to support future debt payments.
• Length of Operations: Businesses that have been operating for a longer period generally have a better chance of loan approval. Typically, lenders require a business to be in operation for at least one to two years. However, for some types of financing, businesses that have been operational for as little as six months may still be eligible.
• Collateral: In secured loans, lenders require you to pledge collateral—something of value, like accounts receivable or real estate—that they can seize if you fail to repay the loan.
• DTI Ratio: Lenders may also evaluate your Debt-to-Income ratio and Debt-Service Coverage Ratio. The DTI ratio compares your monthly personal debt to your gross income, while the DSCR assesses your business’s annual net operating income relative to its total annual debt
• Personal Guarantee: Certain lenders and loan types may require a personal guarantee, which ensures the lender is protected if your business defaults on the loan. In such cases, if your business fails to meet its loan obligations, you will be personally responsible for repaying the debt with your own funds.

In addition to reviewing business loan requirements, it’s also beneficial to understand common issues that could lead to a loan denial. Knowing what to avoid before applying for a business loan can be just as crucial as understanding the application process itself.

How Difficult Is It to Obtain a Business Loan?

In 2023, the Federal Reserve’s Small Business Credit Survey reported that 51% of applications for loans, lines of credit, and merchant cash advances (MCAs) were fully approved, while 28% of small businesses received partial approval for their requested funding amount.

Generally, having better credit improves your chances of qualifying for financing. While it’s still possible to obtain a business loan with poor credit, you should anticipate higher interest rates compared to the average rates for borrowers with better credit.

How Much Loan Amount Can I Apply For?

Typically, business owners can apply for loans up to $5 million. However, the actual loan amount a lender is willing to offer depends on various factors, including your personal and business credit scores, annual revenue, existing debts, length of time in business, and the industry you operate in.

It’s always a good idea to compare offers from different lenders when seeking a loan. One lender might offer a larger loan amount, while another could provide a lower interest rate. Additionally, working with a reputable business broker can help you navigate the loan shopping process and find the best deal.

How Much Collateral Is Required for a Business Loan?

When applying for asset-based financing, such as a real estate loan or equipment financing, the asset you’re financing acts as collateral, often exceeding the amount you’re borrowing. For instance, with a real estate loan, a lender might provide up to 80% of the property’s value. In this case, the property’s value (the collateral) is 20% more than the loan amount.

If you’re using a more liquid asset, such as cash or stocks, as collateral, lenders may be willing to offer a higher loan-to-value (LTV) ratio. For instance, if a certificate of deposit (CD) is used as collateral, you might be able to borrow up to 90% or more of the funds in that account.