Business Tips

How Small Business Loans Work

By
Fiverr Team
|
November 24, 2022
Small Business Loans

There comes a time in almost every business owner’s life when some extra working capital would make a big difference. Whether you’re planning to hire help to scale your business, you need cash to make this week’s payroll, or you’ve come across an exciting expansion opportunity, it’s important to have access to funds when you need it.

Even if you’re not thinking about borrowing right now, you'll want to understand your options when it comes to small business loans. This can help ensure you’re able to quickly get the money you need when the time comes. Here are the basics you need to know.

What Is a Small Business Loan?

A small business loan is a type of financing that is geared toward small business owners. These loans provide you with access to funding, which you repay with interest over time. There are several different types of small business loans to choose from, and each works a bit differently.

Types of Small Business Loans

Understanding the types of small business loans that are available will help you select the option that is most appropriate for your needs. This may vary based on factors such as your personal and business finances, how much money you need, and for how long. Here’s a look at some of the most common options you may consider.

Small Business Lines of Credit

A small business line of credit works sort of like a credit card, allowing you to borrow only what you need up to a specified limit. This can be an economical choice since you’re only paying interest on the amount of money you actually borrow.

Since it's a revolving line of credit, this type of loan allows you to keep drawing funds as often as you need as long as you don’t exceed your credit limit. It's a convenient way to borrow smaller amounts of money throughout the year and can be ideal for things like covering seasonal expenses or funding your holiday marketing campaign.

Small Business Term Loans

With a small business term loan, you’ll typically receive a lump sum of cash, then pay it back with regular payments over a set period of time. These loans often have a fixed interest rate and a repayment period of around five years, though loan terms may vary. They are amortized much like a car loan or mortgage, with part of each payment going towards interest and the rest paying down your principal.

Small business term loans are often used for investments, such as purchasing a piece of equipment, buying a franchise, or expanding into a new location.

Invoice Factoring/Invoice Financing

Invoice factoring or financing, also known as accounts receivables financing, allows you to receive money upfront based on the unpaid invoices you currently have on the books. When you use this type of financing, you are essentially selling your unpaid invoices to a lender in exchange for a percentage of the invoice value upfront. Depending on the arrangement, you may keep the invoices and use them as collateral to get an advance or turn them over to the lender who takes over payment collection.

Accounts receivable financing can be quick and convenient. Since it’s secured by your outstanding invoices, it may be a good option for business owners who have less-than-stellar credit. However, the fees and other costs associated with these types of loans may be more expensive than other options.

Working Capital Loans

While many small business loans are meant for financing longer-term investments, working capital loans are typically used to cover the cost of everyday business operations. This may include meeting your payroll obligations, paying your rent, or making other debt payments.

Working capital loans are often for smaller amounts and have shorter loan periods than other types of small business loans. They may also be linked to your personal credit, which could affect your credit score if you’re unable to make your payments on time.

Equipment Financing

If you need to purchase a specific piece of equipment, you may be able to secure financing directly from the seller or from an outside lender. Unlike most other types of business loans, equipment loans only allow you to use the funds to purchase the specified piece of equipment. The equipment is then used as collateral, meaning that the lender can take it back if you fail to make your payments.

Equipment financing often requires less documentation than other types of loans, so this may be a good option if you need to make a purchase fairly quickly. Since the loan is collateralized, it may also have lower credit score requirements than other lending options.

Small Business Credit Cards

A small business credit card is similar to a personal credit card but may have some additional perks and features. For example, you may be able to get additional cards for your staff with set spending limits. Business credit cards often also have reporting features that allow you to track and categorize your spending and may have special rewards programs for common business expenses.

Where to Get a Small Business Loan

There are several places to secure a small business loan. While banks and other traditional lending institutions were once the primary places to get a loan, today, direct online lenders are a popular option. These lenders use algorithms and technology to streamline their application process. In many cases, borrowers can apply and get approved in just a few days or, sometimes, the same day.

Credit unions, community banks, and large commercial banks are also options you may wish to consider. When working with these types of lenders, you may need to provide more documentation, and the process may be slower. However, you may also be able to save money on fees and may get a lower interest rate.

If you have the time to wait for approval and your financials are strong, you may consider looking for a lender that is backed by the Small Business Association (SBA). SBA loans typically have lower interest rates, longer repayment terms, and lower down payment requirements than other types of loans. However, qualifying for them may also be more difficult.

Finally, you may consider a peer-to-peer (P2) lending platform. These organizations provide funding that comes from a group of investors. It may be easier to qualify for a P2P loan than for other types of loans, but they typically also come with higher interest rates.

How to Qualify for a Small Business Loan

Many business owners are able to qualify for a small business loan without much trouble, particularly if they have strong financials and good credit. If you’re thinking about taking out a small business loan, there are a few things you can do now to set yourself up for success.

1. Build Up Your Credit Scores

It’s common for lenders to examine your personal credit score before approving you for a small business loan. This three-digit number is an indication of how likely you are to repay your loan on time. The higher your credit score, the less risk the lender is taking on by giving you a loan.

Generally, a score of 700 or higher is considered “good,” and a score of 800 or higher is “excellent.” If your score is lower than you would like it to be, you can raise it by focusing on making all of your payments on time and paying down the balance of your debts. Once you’ve built up your personal credit, you can also increase your business credit by forming an LLC or incorporating, getting an Employer Identification Number (EIN), and opening one or more accounts in your business name.

2. Understand the Requirements

Each lender may have different requirements for approving a loan. Typically, they’ll look at things like your credit score, debt-to-income ratio, annual business revenue, and how long you have been in business. As you compare your options, it’s a good idea to find out the lender’s minimum requirements so you can get an idea of whether you’re likely to qualify. It’s often possible to find lenders with more lenient requirements, but since they're taking on more risk by lending to you, they may charge you more in fees and a higher interest rate.  

The lender may also require certain documentation, such as a copy of your driver’s license, profit and loss reports, bank statements, and copies of your personal and business tax returns. Finding out what is required ahead of time can help make the application process easier.

3. Create a Business Plan

If you’re planning to take out a large loan, your lender may request a copy of your business plan. This document provides evidence that you have a valid business and shows the lender that you plan to use the funds in a way that will make the business more profitable. Not only will creating this plan ahead of time help ensure you’re prepared when you apply for your loan, but it can also help you confirm that taking out the loan for the purposes you have in mind is a financially sound idea. For many business owners, hiring a professional to write your business plan is an investment that is well worth the cost.

Important Things to Consider When Taking Out a Small Business Loan

Taking out a business loan isn’t a decision to be taken lightly. It's helpful to make sure you have a clear understanding of your current income and expenses, tax liability, and other financial issues before you take on additional debt. If you're not quite sure where to start or need a bit of extra help, consider contacting one of Fiverr’s freelance financial consultants today!

Fiverr Team
Whether you’re scaling up your small business or building a brand from scratch, we’ve got the resources you need to keep you informed and at the top of your game.
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