How Do Business Loans Work?
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When you take out a business loan, you borrow money from a lender and pay it back over time with interest. Small-business loans can help you expand your business, make up for seasonal gaps in your cash flow, cover expenses during a downturn and more.
In general, all the different types of business loans follow the same basic steps:
You apply for a loan.
A financial institution agrees to lend you a certain amount at a specific cost, including interest and fees.
In exchange, you provide collateral or a personal guarantee to pay the loan back on time.
You receive the funds in a lump sum or as a line of credit.
You pay back what you borrow on a prearranged payment schedule.
If you don’t repay the loan on time, the lender can seize your collateral or other assets.
Let’s dig into two of the broadest categories of business loans: Term loans and lines of credit.
How business term loans work
When you take out a business term loan, you receive a lump sum of cash and then pay it back over time. If you’ve taken out a student loan or a mortgage, business term loans work similarly.
Term loans follow these steps:
Your business applies for a term loan.
The lender agrees to lend you a certain amount and sets an interest rate.
You receive the funds you applied for in one lump sum.
You repay the lender in predetermined amounts on a schedule.
Once the loan is repaid, you’ll have to apply for another loan if you need more funding.
You’ll typically need at least a year in business and strong credit to qualify for a business term loan, though some lenders may make exceptions — usually at a higher cost to the borrower. In addition, you’ll likely need to provide collateral or a personal guarantee.
In general, business term loans best suit companies planning for significant growth. Some are even designed for specific types of development, like equipment financing or commercial real estate loans.
How business lines of credit work
Business lines of credit also fall under the “business loans” umbrella, but they work differently from term loans. Instead of receiving the entire loan at once, you can withdraw what you need as you need it. Your payments are based only on what you’ve withdrawn.
If you’ve ever had a credit card, business lines of credit work similarly.
Business lines of credit follow these steps:
Your business applies for a line of credit.
The lender agrees that you can withdraw funds up to a specific limit and set interest rate.
You can draw on your line of credit as needed.
You repay what you borrowed on a fixed schedule with interest.
Once you’ve repaid what you borrowed, you can withdraw it again. The limit applies to how much you can borrow at one time, not how much you can borrow over the life of the line of credit.
Lines of credit can help fund a business expansion, but they’re also useful for business owners with uneven cash flow who occasionally need credit. In addition, some business owners like to have lines of credit in an emergency.
How to choose a business loan that works for you
The best business loan for you is the one with the most favorable rates and terms among the loans you qualify for.
Most lenders who offer business term loans also provide lines of credit. Here’s what to expect:
Business loans from banks tend to have the lowest interest rates. But they’re also generally the hardest to qualify for and can take longer to fund than other loan options.
Online business loans and lines of credit typically have less stringent application requirements than bank loans and can get funding faster. However, they also tend to have higher interest rates.
If you don’t have the business history, credit or collateral to qualify for financing from a bank or an online lender, you may want to consider alternative business financing. These include:
Business credit cards (like business lines of credit but are easier to qualify for).
Microloans (business term loans of small amounts). The Small Business Administration backs some microloans, and nonprofit lenders offer them.
Invoice financing. With this financing, you receive lump sums of cash by borrowing against your outstanding invoices. The invoices also serve as collateral, so you may be able to qualify even with bad credit.
Merchant cash advances (term loans you repay with a percentage of your future sales).
ACH business loans (a type of merchant cash advance with fixed repayments). Merchant cash advances and ACH business loans are particularly risky and should be an option of last resort.