Getting a small business off the ground is tough work. Capital can be tricky to find and raise. That’s why many entrepreneurs take advantage of business loans to get their companies up and running.
It may surprise you to learn that there are several different types of business loans that cater to specific needs or certain kinds of businesses.
What are the types of business loans – or other kinds of financing – available to you, and what is the best type of loan for your business? In this post, we'll have a look at a handful of the most common lending instruments that can help your business get rolling.
What Are the Different Types of Lending?
There are many different ways to finance your business. Let’s look at the top 11:
1. Term Loan
The term loan is perhaps the most basic, common, and flexible small business loan. It's simply an amount of cash issued in a lump sum that the borrower repays over a fixed amount of time, usually in monthly installments. Term loans can be used for virtually any aspect of your small business, including equipment, marketing, or everyday expenses.
Term loans are beneficial because they can usually be issued quickly – sometimes as soon as one day. Interest payments on term loans are also tax-deductible, and the term can be extended if needed. One downside is that you’ll probably be expected to put up an asset for collateral, which can be seized if the loan defaults.
2. Business Line of Credit
This setup is essentially a business credit card, minus the card. Usually linked to a checking account, a business line of credit comes with a limit set by the issuing bank. A business can borrow money up to that limit. After the borrower repays the debt, they can again take out cash against that limit.
A business line of credit is great when the owner isn’t sure exactly how much money they need. That’s because interest is charged only on the amount they withdraw, unlike a term loan where interest applies to the total amount.
A business line of credit is usually unsecured, so collateral isn't needed. However, it can be hard to qualify for one, and the low interest rates can be offset by extra fees. A line of credit can be useful to get through cashflow crunches if you resist the urge to overuse credit.
3. Small Business Administration (SBA) Loan
SBA loans are backed by the government. They’re attractive to many business owners because of their relatively low cost and interest rates compared to other types of small business loans. SBA loans can be utilized for most business purposes, including start-up, capital, equipment, inventory, real estate, and more.
The biggest downside to an SBA loan is the drawn-out application and approval process, which can extend up to three months before you receive funds. It’s therefore not appropriate for emergency needs, but if you can wait for approval, you’ll enjoy the security and cost savings of an SBA loan.
4. Equipment Financing
Equipment financing helps a business owner buy or replace equipment without having to pay for large items all at once upfront. The owner can pay in monthly installments for major equipment, which is used as collateral.
Equipment financing is helpful because it keeps a business operational without the burden of a big cash dump. It's also a tax benefit because you can write off the full cost of the equipment in the first tax year.
On the downside, the lender can repossess the equipment in case of default – but the owner’s other personal or business assets aren’t threatened.
5. Merchant Cash Advance
In a merchant cash advance, the owner borrows money against expected sales in the future, essentially offering credit card sales as a form of collateral. The owner repays the debt through daily credit card transactions or via weekly transfers of cash from their bank account.
This kind of financing comes with a high risk, simply because future success is never 100% predictable. The interest rates can be extremely high. However, in some cases, the lender may agree to adjust the borrower's payments downward during times when business is slow.
6. Accounts Receivable Financing
There are two kinds of financing (technically not “loans”) that use unpaid customer invoices as instruments to get quick cash.
In this process, the business owner collects a certain number of long-standing, unpaid invoices and sells them to a factoring company for 80% to 90% of the total amount due. The factoring company then takes over collection activities on the outstanding invoices, if needed.
Instead of selling the invoices, the business owner puts them up as collateral for a cash advance. The business is still responsible for collecting on the invoices.
Both of these financing agreements can be more expensive than loans or other instruments, but they can help business owners get through a tight time that’s the result of unpaid invoices.
One issue with invoice factoring is that the owner cedes control of debt collection to a third party. That might cause some unhappiness from loyal customers. With invoicing financing, customers never know their invoices are being used as collateral, but the business owner still must collect on the invoices.
7. Commercial Mortgage Loan
This type of loan is for obtaining real estate or property, whether for starting a new business and upgrading or expanding an old one. The building serves as collateral and gives the owner a chance to increase equity since it’s likely to gain in value over time.
Commercial mortgage loans can be very expensive upfront. Some lenders require good credit and at least two years of business history, which can exclude new companies from getting this type of loan.
8. Startup Business Loan
This nontraditional loan is geared toward absolute beginners in business. It can provide anywhere between $500 and $750,000 to start a business from scratch. You can use a startup loan for everything from equipment and property to inventory and staffing.
A startup loan is an alternative to investor financing, meaning the owner keeps complete ownership of the business without having to answer to a stakeholder. However, these loans can be hard to qualify for, especially for owners with challenging credit history or limited assets for collateral. Plus, if the startup fails, the loan will still be due.
Microloans are typically issued in amounts less than $50,000. They’re good for owners who need a little cash for a one-time business expense or a startup that just doesn’t need a lot of money. Some microloans are issued by the government, while others are offered by nonprofits. Collateral is usually required.
10. Business Credit Card
A business credit card works just like an individual credit card: you use it for purchases under a certain limit and keep up with monthly payments. It’s best for continuing business expenses, including office supplies, utility bills, traveling, and restaurant meals.
Business credit cards are also useful when multiple employees are authorized to spend on the company's behalf. Fees can add up, and interest rates may be a little steep, but in return, you may earn rewards on purchases.
11. Personal Loan for Business
Especially when starting a company, an owner can use a personal loan to finance a business. Most banks won’t offer a business loan to businesses with no history of operations, so a personal loan can stand in its place.
This approach can create a significant risk to one’s personal assets, and qualifying for this loan can be tough. Most personal loans are capped at $50,000, as microloans are. A personal loan is an option for business owners with good credit scores.
Which Loan Is Right for Your Business?
With the wide range of business loans available – there are many we haven’t covered – a business owner must examine each one very carefully. When choosing which one's right for you, take the following steps:
Make an Honest Evaluation of Your Business
How would a potential lender view your business at first look? How strong are its credit score and debt-to-equity ratio? Can it afford the monthly payments with the revenue it generates? Be thorough and candid about the state of your business.
Examine the Interest Rate and Repayment Terms
Weigh the interest rate and terms of repayment in conjunction with each other. A high interest rate may seem unsightly on paper, but it might not be a deal-breaker if the repayment terms are favorable. Get clear on the term length, payment schedule, and whether you can pay the loan off early without penalty.
Ask About Application and Administrative Fees
Some lenders charge a fee just to apply for a loan. They may also charge fees for application-related functions like running a credit check or having collateral appraised. Make sure you know how much of these expenses you’re responsible for.
Even if you consider your business to be in emergency mode, don’t rush any part of your decision-making. Weigh all of your options as deliberately and slowly as you can – making the wrong choice too quickly can be disastrous.
How to Get Approved for a Business Loan
There are many factors a lender will take into consideration before approving a small business loan, and explaining how to qualify for one would take a whole other article. But a few areas to focus on in preparation include the following:
- Keep on top of your credit scores – both business and personal
- Be clear on the requirements and minimum qualifications for the loan
- Have a solid, straightforward business plan ready
- Collect all pertinent legal and financial documents
- Prepare details on the collateral you'll provide if needed
With the right preparation, the process can be a lot less stressful.
Find the Right Loan for Your Business
There are plenty of options for loans and financing available to small businesses of all kinds. Take time to understand each one that’s relevant to your business before deciding.