How Does a Business Loan Work? The Complete Guide
How Do Small Business Loans Work?
Small business loans give business owners access to capital to invest in their business. In the typical small business loan structure, a lender will give a business owner money, which the business owner must pay back, with interest, over a predetermined period of time. There are a variety of business loans available—from term loans to SBA loans to business lines of credit.
Each type of business loan has its own set of requirements and features. The details of your business—like your time in business, financial health, credit score, and available collateral—all play a role in determining the type of business loan you can get. In this guide, we walk through exactly how a small business loan works, with details on how each type of loan functions.
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How Does a Business Loan Work? The Fundamentals
To start, we need to address some fundamentals before we dive into all the answers on how exactly business loans work.
Put simply, this question has a lot of potential answers, all of which can be correct, depending on the situation you find yourself and your business in. Because the market of small business loans is constantly evolving as technology, regulations, and preferences shift, there are infinitely many ways in which a business loan could work.
That said, the easiest way to break down how business loans work is to answer based on what type of business loan you’re dealing with. So, though the various types of business loans are constantly shifting along with the industry they constitute, we’ll attempt to comprehensively answer the question, “How does a business loan work?” by looking at how each type of business loan works.
So, without further ado, let’s get started breaking down how business loans work.
Types of Business Loans and How They Work
Now that you know how we’ll approach answering the question, “How do small business loans work?”—let’s get to it.
The general mechanics of a business loan is something you probably know well: A business loan falls under the category of debt financing, and it’s a way to get the money your business needs to grow.
Business loans are offered by lenders. And in exchange for the money, they’ll charge interest on top of the loan amount—in the most basic loan structure, interest is charged as a percentage of the loan’s principal.
Typically, business loans are paid back over a set amount of time, with regular repayments.
While business loans work with this basic structure, they do vary by the type of business loan they are.
So, when it comes to walking through how a business loan works, we need to answer how each business loan works.
Starting with the simplest type of business loan to understand, progressing to the most complicated one, let’s take a look at how the main types of business loans work.
Term Loan
We’re starting with traditional business term loans because it’s probably what you picture when you picture a business loan.
When your business qualifies for a term loan, it receives an agreed-upon sum of money that it will pay off, plus interest with scheduled monthly payments over an agreed-upon repayment term.
Generally speaking, term loans provide large loan amounts, so if you decide to fund with a term loan, you can gain access to loan amounts that can range anywhere from $25,000 to $500,000.
Plus, they generally offer loan repayment term lengths that are on the longer side, which means that you could have anywhere from one to 5 years to repay your loan.
Finally, term loans generally come with interest rates on the lower side, as well—we’re talking interest rates that can dip as low as 7%. And when it comes to small business loans not from a bank, an interest rate in the single digits is incredibly affordable.
Short-Term Loan
Next up, short-term business loans work a lot like a condensed version of traditional term loans. If you decide to fund with a short-term loan, you’ll still receive an agreed-upon sum of money all at once that you’ll gradually pay off, plus interest, over time.
However, short-term loans come in smaller loan amounts, are paid off over much less time, and carry much higher rates than traditional term loans—that’s why they’re called short-term loans.
Because short-term loans feature condensed, more expensive terms, they’re less easy to pay off than their longer-term counterparts. Shorter terms will mean higher weekly (or even daily) payments, which can be difficult for small businesses to manage in terms of their cash flow.
That said, shorter terms mean a shorter length of time in which interest on your loan will accumulate. Because of this, even though short-term loans have higher interest rates, their overall cost could end up being lower than longer-term loans.
Generally speaking, short-term loans range in size from $2,500 to $250,000, with repayment term lengths as long as 18 months and as short as three months. Plus, their interest rates will never dip into the single digits like long-term loans will—the lowest they start at is 10%. In fact, many short-term loans will have their cost expressed as factor rates—decimals that you simply multiply your loan amount by in order to see how much it will cost you in total—instead of as APRs, in order to better communicate the cost.
Be sure to convert your short-term loan factor rate to APR to get an understanding of what your true cost of capital is.
Equipment Financing
The next type of business loan on our list is equipment financing. Equipment financing is when a business takes on a loan specifically in order to pay for a piece of equipment that it needs. Equipment financing is a type of self-secured loan, meaning that the equipment that you buy with the loan’s proceeds acts as collateral for the loan.
Because equipment financing is centered around the equipment itself, the terms that this type of loan comes with will also rely on the equipment. With equipment financing, you can secure a loan for up to 100% of the value of the piece of equipment that your business needs. Additionally, your loan term for equipment financing will generally be the projected life of the piece of equipment you buy with the loan proceeds.
Finally, because the equipment acts as collateral for the loan, the lender will be taking on less risk by lending to you. As such, your rates will be correspondingly affordable for equipment financing, dipping as low as 8%.
Invoice Financing
Next up on our list is another kind of self-secured loan, invoice financing. This type of business loan provides advanced capital to business owners who are patiently awaiting outstanding invoices. With this type of business loan, you can receive a loan of up to 90% of your invoice’s worth with the invoice itself acting as a form of collateral to the loan. The remaining value of the invoice is held by the invoice factoring company in “reserve,” which will be disbursed to you, less fees, when your customer pays the invoice in full.
Plus, because invoice financing is secured by the invoice itself, you’ll be able to get lower rates on your financings. Rates on invoice financing are typically represented as factor fees, charged on the reserve amount being held by the financing company. You’ll typically be charged a 3% origination fee (or advance fee), and be charged a 1% factor fee each week the invoice goes unpaid (charged on the principal).
Once your customer fulfills the invoice that you finance, you’ll receive the remaining amount of the invoice (for instance, the remaining 10% if you initially finance 90% of your invoice’s value) less the amount that the origination fee and factor fees amount to.
SBA Loans
The next type of business loan on our list is one of the most complicated to understand but one of the most affordable to pay off.
SBA loans are long-term loans offered by banks that are partially guaranteed by a government entity called the Small Business Administration.
What does this mean exactly? Well, when the SBA partially guarantees an SBA loan, it means that they back up part of the loan amount that a small business receives. So, if a borrower isn’t able to pay back an SBA loan, then the SBA will pay the lender the amount that they guaranteed.
Because of this guarantee, lenders are taking on less risk by lending to a small business, and this mitigated risk makes it so that lenders are more willing to lend to small businesses. And when they do lend to small businesses, they offer better terms like lower APRs, higher loan amounts, and longer repayment terms.
Indeed, this partial guarantee makes SBA loans the best deal on the small business loan market. They can range in size from $5,000 to $5 million and in repayment terms as long as 25 years and never shorter than five years.
The best part? SBA loan interest rates can dip as low as 6.5%, which can end up saving tons of money, especially on their monthly payments.
Business Lines of Credit
Second to last on our list of business loan types is the business line of credit. This is another business loan that’s a bit more complicated in how it works, but worth putting in the effort to wrap your head around.
A business line of credit works a lot like a non-physical business credit card—if your business qualifies for a line of credit, it will be extended a credit limit that it can draw from on a month-to-month basis. Like with a business credit card, with a business line of credit, you’ll only have to repay what you end up spending, so you won’t have to end up paying back interest for funds your business doesn’t need. However, unlike with a business credit card, with business lines of credit, you’ll be working with cash and won’t have to pay extra to get a cash advance.
Business lines of credit can range in size from $10,000 to over $1 million and can last anywhere from six months to five years. Plus, their interest rates can be as low as 7% and rarely go higher than 25%.
All in all, a business line of credit is a staple business funding product for small business owners to have in their back pocket to weather the ups and downs that come with running a business.
Merchant Cash Advances
The last and most initially complicated type of business loan on our list is the merchant cash advance. Lenders who offer merchant cash advances consider your business’s future credit card sales to be an asset. Based on this asset, they extend your business an “advance,” which is just a sum of money.
So far, pretty simple, right? Well, the repayment is where it gets kind of complicated. Before the lender extends you your advance, they install technology into your business’s credit card point of sale system—like your business’s cash register, Square, or PayPal, for instance. Then, after they extend you the advance, they’ll intercept your business’s credit card transactions to take a certain daily percentage of your credit card revenues as your repayment.
So, with merchant cash advances, your repayments are money that you never actually see—they redirect automatically to your lender on a daily basis before they even reach your business’s accounts.
This setup is pretty nice, not only because of convenience but also because on days when business is slow, your daily payment will be small. Plus, on holidays when business is zero, your daily payment will be $0. These daily payments will take place until your merchant cash advance amount, plus interest, is paid off in full.
Keep in mind, though, merchant cash advances do tend to be on the more expensive side. Their costs, expressed in factor rates, tend to range anywhere from 1.14 to 1.48. Plus, if business is slow, you could be paying off your merchant cash advance for a long time. That said, because merchant cash advances come with factor rates instead of APRs, you won’t have to pay extra interest if you take extra time to pay it off in full.
How the Business Loan Application Process Works
Now that we’ve covered the fundamental logistics to how each type of business loan works, it’s time to check out how getting each type of business loan works.
Most loan types come with minimum requirements that borrowers need to meet in order to be eligible to apply for the loan. Plus, they all come with their own requirements for documents you’ll need to have in order to apply.
Let’s run through each of the business loan types and what their minimum qualification and their documentation requirements are for their application processes.
Term Loan
A business term loan can be tough to qualify for, but it’s one of the top types of business loans on the market. In order to be eligible to apply for this type of business loan, you and your business need two-plus years in business, 650+ credit score, and $300,000 or more in annual revenue.
If you and your business meet those minimum requirements, you will need to compile paperwork to apply for a short-term loan:
- Driver’s License
- Voided Business Check
- Proof of Ownership
- Bank Statements
- Balance Sheet
- Profit and Loss Statements
- Credit Score
- Personal and Business Tax Returns
Short-Term Loan
On the other hand, the short-term loan provides slightly more accessible funding. In order to be eligible to apply for a short-term loan, you and your business need one-plus years in business, 550+ credit score, and $50,000+ in annual revenue.
If you and your business meet those minimum requirements, you will need to compile paperwork to apply for a short-term loan:
- Driver’s License
- Voided Business Check
- Bank Statements
- Balance Sheet
- Profit and Loss Statements
- Credit Score
- Personal and Business Tax Returns
Equipment Financing
Next up, equipment financing generally carries the minimum requirements of 11+ months in business, 600+ credit score, and $100,000+ in annual revenue. If you and your business can check off all of those boxes, then you can move on in the process of applying for equipment financing—you’ll just need to gather these documents in order to submit an application:
- Driver’s License
- Voided Business Check
- Bank Statements
- Credit Score
- Business Tax Returns
- Equipment Quote
Invoice Financing
In contrast to most other loan types, invoice financing won’t come with a personal credit minimum requirements—you and your business will just need at least six months in business and $50,000+ in annual revenue in order to be eligible to apply for invoice financing. If your business meets those two requirements, then you’ll just need to get these documents together in order to apply:
- Driver’s License
- Voided Business Check
- Bank Statements
- Credit Score
- Outstanding Invoices
SBA Loans
Because they offer the most ideal terms, SBA loans will have the highest minimum requirements—you and your business will need at least two years in business, 620+ credit score, and $100,000+ in annual revenue in order to be eligible to apply for an SBA loan.
Not to mention, because SBA loans involve a government agency, you’ll also need to provide a good deal of paperwork for your application. Be sure to have the following documents compiled when you apply for an SBA loan:
- Driver’s License
- Voided Business Check
- Bank Statements
- Balance Sheet
- Profit and Loss Statements
- Personal and Business Tax Returns
- Business Plan
- Business Debt Schedule
Business Lines of Credit
Just like invoice financing, business lines of credit won’t come with a minimum personal credit score requirement. In order to be eligible to apply for a business line of credit, your business will just need at least six months in business and $50,000+ in annual revenue.
If your business can check off those minimum requirements, then you’ll just need to gather the following paperwork to apply for a business line of credit:
- Driver’s License
- Voided Business Check
- Bank Statements
- Balance Sheet
- Profit and Loss Statements
- Credit Score
- Business Tax Returns
- Personal Tax Returns
Merchant Cash Advances
Last up, merchant cash advances are some of the easiest types of business financing to qualify and apply for. In order to fulfill the minimum requirements for a merchant cash advance, you and your business will just need at least five months in business, 400+ credit score, and $75,000+ in annual revenue.
To apply for a merchant cash advance, you’ll need to gather six documents to submit to your potential lender:
How Does Business Loan Repayment Work?
Each loan type will come with its own requirements for repayment, as that’s one of the main things that separates one loan from another. Term loans, for example, generally offer longer repayment terms, which is helpful for businesses looking to make monthly payments. Short-term loans, on the other hand, typically require weekly or daily payments, which could significantly cut into your cash flow.
Equipment financing is a little different, and the terms of the loan are as long as the projected life of the equipment you buy, so there may not be a set payback plan, as it will change depending on the piece of equipment. Invoice financing is another one where the payback isn’t as traditional as some other loans. You basically pay off the loan once you receive payment on the invoice.
SBA loans are known for being a little complicated, but they are also known for being easier to pay off. The repayment terms are never shorter than five years and can be as long as 25 years. Like SBA loans, business lines of credit can also be complicated but can be paid off in as little as six months or as long as five years.
Finally, merchant cash advances are paid off with daily draws on your credit card sales—provided you make sales each day.
The takeaway here is that business loan repayment differs depending on the type of business loan you have. Always read the loan agreement so you fully understand what you’re signing up for before you take out a loan.
The Bottom Line
There you have it—the de-jargonized answers to the question on every business owner’s mind—”How do business loans work?”
What’s the bottom line for all of this information?
Well, essentially, there’s no definitive, all-encompassing answer to this widespread question. How business loans work is almost entirely situational—so many different factors go into it, that there’s no way to provide an accurate, one-off answer. Because the answer to this question relies so heavily on your business and the type of loan you’re seeking, only you, the one who knows your business best, will be able to decide what the bottom line is.
