More than a quarter of small U.S. businesses had to close down because they completely ran out of funds.
What’s more, 82% of SMBs fail due to cash flow problems. That’s over eight in 10 businesses gone all because of lack of funding!
As scary as those stats are, there’s still some good news. Thanks to business loans, you can keep your business from being part of the statistics.
The question now is, how exactly can these loans do that? How do business loans work in the first place?
We’ll answer all these questions and more, so be sure to read all the way to the end!
1. How Do Business Loans Work: A 200-Word Primer
Lenders, such as banks, credit unions, and online lenders, are all sources of business loans. They pretty much work like a personal loan — you borrow money and pay it back with interest over a set amount of time.
The main difference is, the amount of money you can borrow with a business loan is bigger. After all, these loans serve as a source of funds to cover various business operations. Businesses usually require bigger funds than individuals, so they also need to borrow more.
For instance, some business owners use the loan to fund overhead costs or working capital. Others use it to purchase assets and equipment for their company.
Similar to consumer loans though, a business loan is also repaid back in increments. In most cases, the borrower pays back the lender every month. How many months depends on the term that the borrower and lender agree upon during the contract signing.
Note that this is only the basic structure of most business loans. Meaning, they still vary in terms of the loan amount, interest rate, term, and requirements. Some are also easier to qualify for but carry higher interest rates.
That said, there is no one answer to your question, “how does a small business loan work?” The answer depends on the specific type of business loan you want to apply for.
Don’t worry though, as we’ll walk you through the workings of the most common business loans. This way, you can decide which one will best suit your needs and your ability to pay off a small business loan.
2. Repayment Made Easy with Traditional Long-Term Business Loans
We’ll start off with this one because it’s the most popular loan type.
Traditional business loans are long-term loans that usually provide large principal amounts. Since there’s a lot of money involved, lenders give borrowers a longer period of time to pay it back. Some have three-year terms, while others can run up to 10, even 20 years or longer.
Let’s say your company qualifies for a long-term loan of $50,000 with a 5-year term. The $50,000 is the “principal amount”, which you have five years to pay back. If you choose a monthly payment method, then you’ll pay back the loan, with interest, over 60 months.
These term loans generally also have lower interest rates, with the current bank prime loan rate at 5%. These lower rates make long-term loans some of the lowest-cost business loans today.
These advantages, however, make these loans harder to qualify for. Most traditional lenders place huge importance on business’ credit score and history. In fact, a study found that business credit is the reason lenders reject one in five small business loans.
3. You Have Short-Term Loan Options
Short-term business loans work like long-term loans, except that they’re a condensed version. They have a shorter repayment term, usually three months to two years. And since they have a shorter repayment period, they provide smaller borrowable amounts.
Moreover, short-term loans come with higher interest rates. That’s because lenders also have a shorter amount of time to collect interest payments.
On the bright side, their shortened terms can make them cost less than super long-term loans. After all, lenders have fewer months to charge interest on.
Another advantage of these loans is their more relaxed requirements. Many lenders, especially online fintech companies, have lower business credit requirements.
4. SBA Loans Are Absolutely Worth It
The SBA in SBA loans stands for Small Business Administration, a government entity. Interestingly, the loan money itself doesn’t come from the SBA. Instead, the SBA serves as a sort of “guarantor” for the loan.
When a small business qualifies for an SBA loan, the SBA backs up a portion of that loan amount. If the borrower can’t pay back the loan, the SBA will pay back the amount that they guaranteed. Depending on the specific loan, the SBA guarantees between 50% to 85% of the loan amount.
Let’s say you qualify for a $100,000-loan and the SBA backs up 85% of it. In case of a default, the SBA will take responsibility for the $85,000 to pay back the lender.
SBA loans can be quite complicated, but they are definitely worth applying for. In 2018, 60,353 SBA 7(a) loans (the administration’s primary program) received approval. These loans had a total value of almost $25.4 billion.
5. You Can Borrow Against Your Outstanding Invoices
The average small business in the U.S. is sitting on about $84,000 worth of unpaid invoices. That’s a lot of money that your business should be able to use but can’t because clients haven’t paid them yet.
The good news is, invoice factoring companies can liquidate them for you. They can give you a loan of up to 90% of the actual value of your unpaid invoices. Your invoices serve as collateral, making invoice factoring a type of secured loan.
The lender will hold on to the unpaid portion of the invoice until the client pays it. You’ll then receive the rest, less the loan fees once the invoice is completely paid.
6. You Can Take out a Loan for Business Equipment
If you need funds to invest in company equipment, you can apply for equipment financing. This is another type of secured loan, wherein the equipment you buy serves as the collateral.
Since there’s collateral involved, the lender takes on fewer default risks. As such, they can afford to charge lower interest rates even on loans that cover 100% of the equipment’s price.
7. Business Loans Can Help Your Business Survive and Thrive
A study found that companies with business loans are more profitable. In fact, their revenues were four times bigger than those with a personal loan.
But that’s not all.
The researchers also found business loans to be a key factor in the survival of small businesses. Business borrowers were 19% more likely to get past their third year than those without debt.
As you can see, taking on a business loan may help your company make it through the years. Since you’d want to celebrate many years in business, then securing a loan may be your best choice.
Don’t Let Your Business Run out of Funds: Consider Taking out a Business Loan
There you have it, the most important facts that answer the question, “how do business loans work?” Now that you know more about them, you can make smart borrowing choices to help your business succeed.
And if you do decide to take on business debt, be sure to explore all your options. There’s more than one type of business loan and there’s definitely more than one lender. Take your time in comparing them so you can choose the best one for your business’ needs.
Looking for more guides like this to get your business going? Then head over to our site’s “Business” page and save it in your bookmarks list!