4 types of loans every business owner should understand
The ability to access capital is important for many growing small businesses, whether one is looking to invest in infrastructure, increase inventory, or simply keep operations running.
There are two primary options to enable a business to receive funding: taking out loans or bringing in investors. While both have their strengths, loans tend to be more popular because they often require less outside input on how to run your business, have tax-deductible interest payments with lower rates, and terms that can be set based on expected receivables.
Small business lending increased by 10.4% in 2013 according to the U.S. Small Business Administration. That progress is expected to continue this year. However, despite this uptick, the National Federation of Independent Businesses found that in December 2013 only 32% of small businesses were able to satisfy their need for borrowed capital. As a result, business owners can benefit from knowing more about how to maximize their chances of getting approved for a loan.
An important step to securing capital for your company is determining the loan option that best fits your company’s needs. Here are four common types of small business loans available:
One of the most common types of loans distributed by large commercial lenders. They are often used for business expansion, acquisition, refinancing, or working capital. Long-term loans are typically repaid on a monthly basis, and tend to be in larger amounts and with lower interest rates than short-term loans. They are generally easier to obtain if you have a well-established business, or a younger business with a strong growth plan.
Rather than requiring monthly payments, short-term loans are due, in full, at the end of the agreed-upon term. These loans are often used for shorter term needs: to build up inventory, raise cash for accounts payable, or complete small projects that yield quick returns, and are usually below $100,000. They are especially useful for seasonal businesses, including retailers, and are issued by banks and credit unions.
Lines of Credit
Rather than receiving a lump sum, opening a line of credit allows a small business to access funds incrementally as needs arise, much like using a credit card. The compounded interest and fees can be high, so credit lines are best used for temporary shortfalls in income, rather than expansion or business improvements. They are distributed by banks and other licensed lenders.
There is a variety of non-bank lending products available, such as leasebacks, cash advances, asset-based loans, peer-to-peer loans, and crowdfunding resources. These can be used for anything from starting a business, meeting cash shortfalls, or financing small-scale expansion. However, they are typically much smaller than bank loans and often have higher interest rates.
Once you’ve identified the type of loan that best suits your business’s needs, you should develop a plan to maximize your chances of securing financing. These are some helpful steps to present a compelling package to a lender:
- Identify sources of existing and requested funds and clearly outline how they will be used.
- Provide any existing business audits for the past few years, as well as interim financial statements that show positive cash flow. This positive cash flow would demonstrate your ability to cover interest payments and principal on a loan.
- Understand your credit score. If there are problems with it, be prepared to describe how you are addressing them.
- Determine the value of your business — which is the amount a buyer would be willing to pay at a specific time. This valuation helps determine how much capital a lender may issue at a given interest rate. Lenders also need to know the value of a business ahead of time in the case of a loan default.
Ultimately, qualifying for a small business loan is a serious undertaking and there are many factors to take into consideration. Be sure to maintain close communication with potential lenders because when financial institutions are evaluating future prospects of a small business, it’s important that they understand not just the business model, the landscape, and the product, but also the team behind it. In turn, this enables the lender to offer the best advice for you to help your small business grow.
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