How Do Small Business Loans Work?

  • Accracy
  • 26th Nov, 2023

When you have big dreams for your small business, the biggest obstacle is often capital. There are dozens of financing options out there, which can make research a headache, so we've put together a comprehensive loan guide for small businesses, answering some of the most common questions.

How Do Small Business Loans Work?

Why should I get a small business loan?

If you run a healthy business, you may wonder why you'd need to take on debt. Some of the most popular reasons for borrowing include:

  • Covering day-to-day business expenses
  • Increasing inventory
  • Purchasing big assets like equipment
  • Paying down debt
  • Purchasing commercial real estate
  • A big marketing push
  • Hiring employees

Most lenders will want to know exactly how you intend to spend the money, so draw up a business plan before you apply. Some may place conditions on lending, such as the type of investment you are allowed to make, so be clear and accurate with your intentions.

If all you need is enough working capital to meet today's business needs, that's fine. But you need to be able to show (to yourself, and to lenders) that there will eventually be some kind of return for that capital.


What's a normal loan amount?

There is no normal loan amount for small business owners. But there is a rule of thumb. Ideally, the profits the loan brings in should cover your repayments, and then some.

Here's how to work that out:

Step one: Figure out what your monthly costs will be (include everything from taxes to payroll to loan payments). Don't forget to include the Annual Percentage Rate (APR) of the loan when considering the repayments.

Step two: Make an educated guess as to what your monthly revenue will be, with the help of the loan. Start with your current monthly revenue, and add in a conservative estimate of how much revenue the loan will add, if any.

Step three: Subtract your future monthly revenue from your future monthly costs. Ideally, the result is a monthly profit.

Maybe as you do the monthly math, you lose money for the first 6 months, and more than make up for it in the last 6 months. That's fine. Just make sure you have enough money to cover your costs, make your loan payments, and in the end, make the loan worth your time.

How do I qualify for a loan?

Different lenders look for different things in an applicant. But the basics qualifiers for business financing include:

  • A good personal credit score (business owner)
  • A good business credit score
  • Minimum operation time (e.g., your business must have been up and running for at least 9 months prior to the application date)
  • Minimum annual revenue

What's a "good" credit score? Here's a rough ballpark, depending on the loan type:

  • Short-term business loan — 550
  • Equipment financing — 600
  • SBAs (Small Business Administration loans) — 640
  • Traditional bank loans — 700+

In addition to a stellar credit score, lenders will ask for evidence to support your application—like income statements, cash flow statements and balance sheets. They might also ask for legal documents, bank statements, tax returns, and a list of any assets the company owns.

Check the loan application requirements before you get started to make sure you have everything you need. If you don't have financial statements, you can always work with an online bookkeeping service like Accracy to do some catch-up bookkeeping and get the historical financial statements you'll need.

The loan application process usually works like this:

  • You speak with a bank rep and fill out a loan application
  • You provide the lender with all the documents they request (in some cases, there may be back-and-forth discussion about your business and what you'd like)
  • Wait a few days or weeks for the lender to approve (or deny) your application
  • If approved, you'll sign a contract agreeing to the loan terms
  • The agreed-on amount will be deposited into your bank account and you'll pay an origination fee

Further reading: How to Get a Small Business Loan


Types of small business loans

We've outlined the main types of loans for business owners, to help you narrow down your choice. Heads up, some of these aren't technically loans, but accomplish the same thing.

Small Business Administration (SBA) loan

The SBA loan program is a long-term loan, guaranteed by the Small Business Administration. With some of the most attractive interest rates and loan terms, they're arguably the best loan you can get. But they're tricky to get your hands on without good finances and a solid credit history.

  • Repaid over 5-25 years
  • Backed by the US government
  • Interest starts at ~7.75%
  • Can be used for almost any business purpose
  • Max. $5k"“$5m
  • Very stringent application requirements

Best for: businesses that have operated for at least 2 years, with proven financial track record and a credit score of at least 640.

Business term loan

A traditional loan, usually provided by a bank, with a set repayment schedule and fixed interest.

Lenders earn money on the loan interest you pay. So if you try to pay your loan off early, you might be charged a penalty fee (since the lender is making less money from you than they originally thought).

  • Repaid over 1"“5 years, usually with monthly payments
  • Fixed interest rates of ~7"“30%
  • Can incur early repayment fees
  • Usually used for large, one-off business investments
  • Few use restrictions
  • Max. $25k"“$500k
  • Stringent application requirements

Best for: predictable businesses with steady cash flow and a credit score of 680 or more, looking to finance something big.

Further reading: How to Calculate Your "Cost of Debt"

Business line of credit

Establish a credit limit, but only repay what you use—plus interest.

  • Repaid over 6 months to 5 years
  • Interest between ~7"“25%
  • Useful to stop cash flow gaps and emergency credit
  • Borrow a fixed amount, pay back only what is withdrawn (plus interest)
  • Max. $10k"“$1m
  • May require collateral
  • Very flexible
  • Low credit score may be acceptable

Lines of credit are best for: less established businesses, or owners looking to build a credit score.

Equipment financing

Otherwise known as an equipment loan. Borrow to buy equipment, using the purchase as loan collateral. For example, a farmer might use equipment financing to purchase a tractor. If they do not pay back the loan, the tractor can be taken by the lender—a little bit like a mortgage.

  • Borrowed up to life expectancy of equipment
  • Up to 100% of equipment value
  • Interest ~8"“30%
  • Purchased equipment acts as collateral
  • Can only be used for stated equipment purchase
  • Quick cash, simpler paperwork
  • Low credit score may be acceptable

Best for: businesses looking to purchase equipment quickly, or who cannot qualify for an SBA loan to cover an equipment purchase.

Merchant cash advance

Not technically a loan, but an advance on sales. Repaid as a cut of your credit card sales. Instead of interest, MCAs charge a "factor fee", which is a multiple of the amount advanced. For example, an MCA with a factor fee of 1.1 means for every dollar borrowed, $1.10 must be paid back.

  • Cash advance in exchange for a percentage of daily sales, plus fees
  • Repaid daily
  • Factor fee ~1.14"“1.18%
  • Suitable for multiple expenses
  • Can impact cash flow
  • Quick cash, simple approvals
  • No collateral needed
  • Low or bad credit score may be acceptable

Best for: businesses that make a large proportion of income through credit card sales, such as restaurants. Useful when looking for short-term financing to resolve cash flow gaps or cover unexpected expenses.

Invoice factoring

If your business gets paid through client invoices, you can always explore invoice factoring. A factoring company will pay you 80% of the value of a client invoice today, and the final 20% once the client actually pays you. The catch is, you pay the company 0.5-5% of the total of the invoice. The upside is, the factoring company takes responsibility for the whole process, including making sure the client pays the invoice.

"Invoice financing" is similar but slightly different. That's where you show a lender an invoice and get a loan against that amount (but in every other way, it's a regular loan, and you maintain responsibility for the invoice payment).

Short-term loans

Finance short-term goals, with loan repayment averaging 3"“18 months.

  • Repaid over 3"“18 months, usually with monthly payments
  • Interest starts at ~10%
  • Max. $2.5k"“$250k
  • Suitable for a variety of costs
  • Low or bad credit score may be acceptable

Best for: businesses with strong cash flow, looking for a shorter repayment commitment.

Personal business loan

For a loan that doesn't take your business revenue into account, try a personal loan.

  • Repaid over 3"“5 years
  • Interest ~5.99"“36% APR
  • Should have good personal credit
  • Business credit not taken into account
  • Business lifetime not taken into account
  • Can have more competitive interest rates than a business loan
  • Max. $35k

Best for: new business owners with a strong personal credit score, who don't mind muddying the waters between their corporate and personal finances.

Further reading: Should I Fund My Business With a Business Loan, or a Personal Loan?

Credit union loans

Credit unions work a bit differently than a traditional bank, since they're membership-based non-profits (yes, a non-profit bank!). If you need a loan and you're already a member of a credit union, you should start your loan search there. Their loan rates are some of the lowest you'll find. And if you have a spotty credit history, but a solid relationship with your credit union, you're much more likely to get approved for a loan there compared to a traditional bank.

Business credit cards

Getting a credit card for your business obviously isn't a loan. But if the above loan options don't for you, a business credit card can give you some flexibility with your working capital. For example, if you sign up for the US Bank Business Platinum card, they'll offer you 0% APR and no fees for the first 12 months. Assuming you can pay your credit card balance in full in that time, it's effectively a free loan. Credit cards can also give you short-term flexibility when you need to make a purchase today, but your client won't pay their invoice until next week.

Further reading: The Best Small Business Credit Cards [2023]

What about online lenders?

You don't need to go to a bank to get a loan anymore. Online lenders (such as Biz2Credit, LendingClub, Kabbage, and many others) can help you get approved for a loan much faster than a bank, and sometimes at more competitive rates. Since all they do is lending, and they don't have the overhead of big banks, they can get you better loan terms.

Just do your due diligence before you start the loan application process online. The above online lenders are reputable. But be sure to read real customer reviews on third-party sites, and watch out for sky-high interest rates and shaky approval processes (like skipping a credit check).

The best small business loans right now

The best loan is the one with the most competitive rates and the easiest application requirements.

To calculate the best loan for you, we recommend using NerdWallet's Loan Comparison tool. You'll always find the most competitive loan on the market there.

What interest rates and fees should I expect?

The more stable and reliable your business, the better your interest rate (since you're less of a risk to the lender). Less stable businesses will face steeper rates.

Your credit score is a major factor in what interest rate you will be charged—low scores indicate high risk for lenders, so the higher your credit score, the lower your interest rate is likely to be. Interest rates are also dependent on the type of loan, and the lender's own business model, so it's worth shopping around for the best deal.

Loan comparison sites such as NerdWallet can save some legwork, or you can go it the old-fashioned way and ask for a quote.

Heads up: when lenders do a credit score check, this can sometimes affect your credit score a little bit. But if you do all your comparisons within a 30 day window, the credit score companies sometimes will recognize you're looking for a quote and won't ding you. To be safe, wait until you're ready to apply before getting quotes.

Fees to be aware of

Most lenders will charge you an origination fee (or processing fee) for getting your loan set up. According to Investopedia, the origination fee is usually between 0.5-1.0% of the total loan amount.

Many lenders will also charge you a "repayment" fee for paying your loan off early. Why would they punish you for paying them faster? Because you're depriving them of the interest income they planned on earning over the full term of the loan.

Which lender should I choose?

Choosing a lender is a personal decision, based on a number of factors. When looking for a lender, consider:

  • Lender reputation
  • APR (annual percentage rate of the loan)
  • How well you meet the lender's criteria
  • Positive customer reviews
  • Speed of the loan (how fast is the application process? And how soon can you get the money?)

If you're unsure about a lender, check out Google Reviews or TrustPilot and search for the lender's name. Real reviews from customers will give you an idea of a lender's strengths and weaknesses. Your loan will likely have a multi-year repayment term, so look out for any history of poor customer service, or reports of costly errors from grumpy consumers.

The best small business loans in 2021

There are many different kinds of business loans. To that end, we've outlined nine of the very best small business loans in 2023 here.

As a quick summary:

  • Best traditional bank loan: Wells Fargo
  • Best choice for SBA loans: SmartBiz
  • Best startup loan: Kabbage
  • Best short-term loan: Streetshares
  • Best P2P loan: Funding Circle
  • Best low-rate loan: Lendio
  • Best line of credit lender: BlueVine
  • Best online invoice factoring lender: Breakout Capital
  • Best loan for bad credit: OnDeck

How soon will I get the money?

If you're going to the bank today to apply for a loan, you should expect to wait at least one week (or even up to one month) to get the money deposited into your bank account. The application process takes time, then the bank has to decide whether they want to approve your loan application or not, and then it will take a few business days for the money to end up in your account.

What should I avoid?

Unfortunately, predatory lenders do exist, so you should watch out for red flags. Signs you should look elsewhere include:

  • Interest rates significantly above market value
  • Fees more than 5% of the loan value
  • Failure to disclose APR
  • Failure to provide a full repayment schedule
  • Pressure to take a loan
  • Pressure to lie on paperwork or leave boxes blank

When in doubt, consult a financial professional. A reputable lender will not pressure you to sign straight away, and will respect your decision to do due diligence before signing on the dotted line.

Can't afford a loan? You might qualify for a grant. Check out our complete dictionary to U.S. small business grants.

Learn More: Shareholder Loan
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