How do Business Loans Work?

A business loan could provide you with money to help your business grow. Find out how business loans work and how to get the right one for your business.

Sarah Bridge Published on 10 March 2021. Last updated on 11 March 2021.
How do Business Loans Work?

What is a business loan?

As the name suggests, business loans are specifically for business use and can range in length, from just a few weeks to several years.

Business loans work much in the same way as standard personal loans. You make an application for a specific amount to a lender, usually a bank or a building society, and they will assess whether they want to lend to you and if so, at what interest rate.

If they make you an offer, you can decide if the lender’s terms are acceptable and once the deal is agreed upon, you will receive the full loan amount. You will then be obliged to repay the amount, plus interest, over the lifetime of the loan in monthly payments.

Specific business loans vary from lender to lender but overall, they tend to be for between £1,000 and £50,000 and the amount you can borrow will depend on many factors including the size of your business and its financial health.

If you fail to keep up those monthly repayments it could mean that you are charged a late or missed payment penalty fee or could lose any assets which you put up as security for the loan.

>>MORE: Business Loans vs Personal Loans

What are the different types of business loan?

There are several types of business loans but broadly speaking they can all be described as unsecured loans or secured loans.

Unsecured loans

Unsecured loans mean that you can borrow money without using a business asset – which is anything of value such as property, machinery or stock – as security for the loan.

Secured loans

A secured loan means that you are obliged to put an asset - such as property, machinery or stock – up as security for the loan. If you are unable to repay the loan or fall significantly behind on repayments, then you are at risk of having that asset seized by the lender.

As unsecured loans do not come with an asset as security, they are likely to attract a higher rate of interest, meaning the total you pay back will be higher than with a secured loan. However, the advantage of an unsecured loan is that you are not at risk of losing an important asset such as your home or a crucial item of machinery if you cannot repay the loan.

What government-backed business loans are available?

If your business is a start-up then you might find it hard to borrow from a traditional lender as you will not have much of a financial track record to show, and it is unlikely that you will be making a profit just yet. Instead, you can apply for a Start Up Loan from the government.

>>MORE: How Can I Get a Start up Business Loan?

What are business loans used for?

The lender is likely to want to know what the business loan will be used for before deciding whether to lend. The main thing to consider is that business loans cannot be used for personal reasons, such as a new family car or a holiday.

There are many different reasons why businesses take out business loans but some common purposes are:

Cashflow

This can cover several things such as buying new stock, equipment repairs, to cover a bad debt or to tide a business over during the low season for seasonal business.

Asset purchase

Big purchases are not easily met from day-to-day cash reserves so you might need to take out a loan to meet the cost of printers, machinery, vehicles and construction equipment.

Property costs

Whether it’s making a hefty deposit payment on business premises or a bridging loan to tide you over during a move, property costs could be met with a short or long-term loan.

Long-term finance

This can include large investment costs which will take some time to bring increased revenue into the business, such as research and development, launching a new business division or product line, restructuring the company or undertaking a big expansion project.

What is the right loan for my business?

Choosing the right loan for your business is a crucial decision. You need to weigh up a number of factors that will determine what the right loan is for you. These include:

How much you want to borrow

Applying for a loan can be a lengthy and time-consuming process. You don't want to have to do this several times because the amount you borrowed was not enough for the task you were hoping to achieve with the loan. Work out exactly how much the project you are borrowing for will cost and include a contingency amount in case costs rise unexpectedly.

You also need to remember that you will have to pay interest on the whole of the loan so if you borrow too much for your needs you will be incurring unnecessary costs.

How much you can pay back each month

This will determine how much you will want to borrow and how long you want to borrow it for. A shorter loan term means you will pay less in interest but your monthly repayments will be higher than if you are borrowing over the long term. Make sure you include the interest on top of the loan when working out your monthly repayments and any loan fees which might be applied.

Whether you want a fixed or variable interest rate

Loans are usually fixed rate, where the interest rate is fixed for the length of the loan, or variable rate, where the interest rate can change if the Bank of England changes its base rate.

With fixed rate loans you will know exactly how much your repayments will be each month which could make it easier for you to plan your outgoings in advance. However, if interest rates go down then you could miss out on potential savings. Equally, if they go up then you have the security of knowing that your interest rate will remain unchanged.

With variable rate loans, you could benefit from a fall in interest rates which would reduce your monthly payments but they are likely to increase if interest rates go up.

If there are any extra fees and restrictions

It is crucial you understand exactly what type of loan you are applying for. Are there fees payable such as administration or application fees? Are there any early repayment charges if you pay off your loan earlier than expected? Will you be able to borrow more, extend the loan or change your repayments during the loan if necessary or is it fixed? Take your time to compare the different loans available from different lenders.

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About the author:

Sarah Bridge has been writing about business and finance since 2000. She was formerly Deputy Editor, Personal Finance, The Mail on Sunday and was previously the paper's Leisure Correspondent. Read more

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