How Do Small Business Loans Work?

Last Updated on May 9, 2021 by MoneyVisual

As a small business, you’ve probably thought about applying for a loan without actually knowing what it is or what it’s all about.

Small Business

When it comes to small business loans, the general understanding is that it’s a way for small businesses to “borrow” money. However, it goes much deeper than that. So, if you want to capitalize on what small business loans bring to the table, you need to grasp the entire concept fully.

That’s why in this article, we’re going to discuss everything you need to know about the small business loan – specifically, how it works.

So, How Do Small Business Loans Work?

Small business loans are grants that provide small business loans access to funds that will be used to invest in their business. The structure of a typical small business loan involves a lender giving a business funding. While it may seem like borrowing, there’s a catch to this: interest. Small business loans are paid in full, along with interest, over a predetermined period.

Let’s say a business owner loaned for $100,000 with 10% interest. That means the total amount that they’ll be paying is $110,000 over a given period. Of course, this example is only the most basic small business loan structure. There are a different types of business loans. Business lines of credit, Small Business Administration (SBA) loan, and term loans are just a few examples.

Before you apply for a loan, it’s essential to know and understand the terms and conditions involving the particular type of loan you’re applying for. Every kind of business loan has its unique set of features and requirements. Details about your business will play a role in the type of business loan you can get. In most cases, the loan provider will look at the following information about your business:

  • Time in business
  • Financial health
  • Credit score
  • Available collateral

Before we delve deeper into understanding how a business loan works, let’s first discuss some fundamentals.

The Fundamentals

You’re probably aware of the general mechanics of a business loan. Business loans fall under the category of debt financing. It’s a way to get the funds that you need to invest in your business. Whether it’s for expansion, acquiring new assets, or creating a new product, the money you get from a loan will be used for business growth.

Lenders are the ones who offer small business loans. In exchange for the money you will borrow, they will charge interest on top of the loan amount. Again, like the example we just showed earlier, the most basic loan structure features interest charged as a percentage of the loan’s principal amount.

Usually, business loans are paid back over a set period, along with regular repayments. While most small business loans follow the basic structure, they also vary depending on the type of loan. So, again, there are different types of business loans available.

The Five Types of Business Loans

To answer the question “How do small business loans work?” we need to know how each of these business loans works. That way, we will get a full picture of how loans function. We’ll start with the simplest and work our way to the most complex types of business loans.

Term Loan

Let’s start this list with the most traditional type of business loan. This type of loan is probably what you also picture when you think about a business loan. A term loan is the type of loan that most businesses qualify for. The business received an agreed-upon sum of money that it will pay off with interest. Payment is done per month over an agreed-upon repayment term, such as a $100,000 loan with 10% interest, payable within 12 months.

Term loans provide large amounts. That means if you decide to apply for a term loan, you can potentially gain access to funding that ranges anywhere from $25,000 to $500,000. In addition, term loan also offers longer repayment term lengths. For example, you can apply for a loan that’s repayable for one to five years.

Probably the best part about term loans is that they also come with lower interest rates. To give you an idea, term loan interest rates can go as low as 7%. So when it comes to small business loans from a bank, single-digit interest rates are incredibly affordable and enticing.

Short-Term Loan

The short-term loan works like traditional loans. Funding with a short-term loan will still grant you the sum that you need, plus interest, over time. However, here’s the catch: short-term loans come with smaller loan amounts. As a result, they are paid off in lesser time and carry higher interest rates than traditional loans. That’s why they’re called “short-term” loans.

Since short-term loans offer more condensed and more expensive terms, they’re much harder to pay off than traditional, long-term loans. In addition, short-term loans mean higher weekly payments – some even request daily payments. So if you’re a small business owner juggling through your day-to-day operations while keeping your finances stable, this type of loan can be challenging to handle.

However, the good thing about the short-term loan is that the length of time your loan interest will accumulate will also be shorter. So even though short-term loans have higher interest rates, their overall costs could be cheaper than long-term loans. 

Regarding the amount of funding you can get, short-term loans generally sit between the $2,500 to $250,000 range. Repayment term lengths can go as short as three months and go as long as 18 months at most. In addition, their interest rates will never go down to single digits – the lowest it can offer is 10%.

Equipment Financing Loan

As the name implies, equipment financing is a type of loan used specifically to pay for one or multiple types of equipment. All the terms of equipment financing will heavily rely on the equipment itself. Equipment financing lets you secure a loan that equals 100% the value of the piece of equipment you will purchase for your business. In addition, the loan term for equipment financing will equal the projected life span of the equipment that you bought with the loan money.

Finally, since equipment financing works as a self-secure loan, the equipment you purchase will also act as collateral. That means if you are unable to pay off your loan completely, the lender can take the equipment that you bought using the loan’s proceeds. That also means the lender will be taking a lesser risk by lending the money to you. Interest rates are also pretty low, starting at 8%.

Invoice Financing Loan

Another type of secured financing loan is invoice financing. This type of loan grants capital to businesses waiting for their outstanding invoices to be settled by their clients/customers. This type of business loan will grant you up to 90% of the total worth of your invoice.

This amount will also act as a form of collateral to the loan. The lender will then hold the remaining value of your invoice as a “reserve.” It will be disbursed to you, with fewer fees, when your customer pays the invoice in full.

Like equipment financing, you will get lesser interest rates since your outstanding invoice secures the loan.

SBA Loans

SBA loans are highly considered the most complicated to understand yet the most affordable to pay off. An SBA Loan is a type of long-term loan offered by partially guaranteed banks by a government entity known as the Small Business Administration (SBA).

The SBA itself partially guarantees an SBA loan that a business receives. That means if the borrowing business is unable to pay back an SBA loan, the SBA will be the one to pay the amount that they guaranteed.

Lenders are notorious for being skeptical about small businesses applying for a loan. That’s why the SBA created this type of loan to help both the lender and the small business. The partial guarantee from the SBA will ensure that lenders are taking lesser risks when lending to a small business. At the same time, it also mitigates the risks, which will make them more willing to lend to small businesses.

All of these terms make SBA one of the best deals on the small business loan market. Loan amounts can go as low as $5,000 to as high as $5 million. In addition, the repayment is never shorter than five years and can even go as long as 25 years, depending on the loan amount.

The best part is about SBA loans is the interest rates, which can go as low as 6.5%. That means a small business can save tons of money, especially on their loan payments. The only struggle that you will encounter when it comes to SBA is the application process. SBA will require a lot of requirements, as well as a lengthy processing period before your small business gets the loan approval.

Business Lines of Credit

Finally, we have business line of credit. This type of loan works similarly to a non-physical business credit card. If your business qualifies for a line of credit, its credit limit will be extended in which it can draw monthly. Like a typical business credit card, business line, or credit will only require you to pay the amount you spent.

That means you won’t have to pay back interest for funds that your business doesn’t need or didn’t spend. The only difference is that you’ll be working with cash in a business line of credit and won’t have to pay extra to get a cash advance.

Business lines of credit loan amount can range from a measly $1,000 to a whopping $1 million. Repayment can last anywhere from six months to five years. In addition, their interest can go as low as 7% and never go beyond 25%.

Conclusion

By understanding how each type of small business loan works, you can also determine which one works best for you. Keep in mind that small business loans are pretty similar to regular business loans. The only difference is the types of loans you can get, as well as the opportunities that are available for you. If you want to apply for a loan, make sure you choose the right one. That way, you won’t encounter any problems or issues while paying your loan.