How Do Business Loans Work? Your 5-Step Guide to Funding
Many entrepreneurs worry that getting a loan for their business is going to be complicated and time-consuming. The truth is that it’s not as difficult as it appears as long as you have the right plan in place. So, how do business loans work, and what can you do to improve your chances of getting the funding you need?
In this article, we show you how to navigate the borrowing process with confidence from beginning to end.
How Do Business Loans Work?
Depending on the financial institutions you approach and the type of loan you apply for, it may take between 24 hours and a few weeks to get the capital you require.
To give yourself the best chance of success, it’s important to understand how business loans work and the steps of the process you can expect.
Step 1: Choose the Right Funding Option for Your Business
With a traditional business term loan, you borrow a fixed amount of money over an agreed length of time. You make monthly repayments during that period until you eventually settle your loan account in full.
While popular and useful, term loans may not be the best choice for you. You should look around the market to find out which loan option or type of funding is right for your particular circumstances.
Four popular alternatives to bank loans are:
Invoice financing: Sometimes called invoice factoring, this option is ideal if your customers aren’t paying you quickly enough and it’s making day-to-day cash flow management difficult. Invoice factoring is a kind of short-term loan against individual invoices your customers have not settled yet (also known as your accounts receivables).
Working capital advance: A short-term working capital loan may be a better business financing option for companies that have seasonal fluctuations in revenues or that receive an unexpected bill. While the interest rate on working capital advances may be higher than a long-term loan, they can cost you less overall since you repay them over a much shorter period of time.
Equipment financing and leasing: Equipment loans are ideal if you need assets for your business that do not have high residual values — in other words, they won’t be particularly valuable in five or 10 years’ time. Equipment finance offers generally have lower interest rates, and because the facility is secured by the equipment you’re bringing in (the collateral is built right in), your application may be more likely to be approved.
Business lines of credit: This is a more flexible option for businesses wanting to have a reserve of cash available to them without being tied to a fixed-term loan. A business line of credit lets companies borrow money up to a set limit. You only pay interest on the money you actually borrow. When you pay back what you borrowed, you can borrow it again.
Step 2: Find the Right Lender
Now that you know the type of financing you need, make a list of the business banks, credit unions, and online lenders that might be able to help you. You may also want to look into the available U.S. Small Business Administration loan programs.
Points to consider are:
Some lenders may offer a wide range of financial products while others restrict themselves to one or two. You may get a better deal from a specialist provider rather than a generic provider.
Some traditional lenders prefer to deal with companies that already have an account with them. For example, a traditional bank may only work with borrowers who have their business bank account with them.
Some financial institutions prefer to work with specific types of businesses or businesses with minimum turnover volumes.
Step 3: Review the Criteria and Prepare Your Small Business Loan Application
Next, you’ll want to look at the eligibility criteria for your list of potential lenders. This will help decide which lender to work with and prepare for your application.
One of the things your lender will evaluate is your creditworthiness. When you apply for a business loan, lenders order credit reports from agencies like Equifax or Dun & Bradstreet. These reports are detailed records that show lenders how much debt you currently have and how successful you are in making repayments on your debt and other bills.
Lenders may also check your business and personal credit scores. Think of a credit score like a scorecard evaluating how well you manage your finances. For example, they may look at the following scores from Dun & Bradstreet:
Delinquency Predictor Score: This is an estimate of how likely you are to stay in business and meet your repayment obligations.
Maximum Credit Recommendation: D&B suggests a maximum amount of money (also known as a credit limit) that a lender should advance to a borrower.
PAYDEX: This is similar to a FICO Score and is designed to show lenders how well you meet your current financial obligations. A score of 80 or higher is considered a good credit score, and a score of 49 or lower is considered a bad credit score.
If you do not have a perfect credit score but you submit a strong application, you may still receive an offer from a lender but have to pay higher interest rates.
To make yourself as creditworthy as possible, pay your bills on time, keep your credit card balances low, and regularly check your credit reports for errors. It’s also a good idea to make sure you keep your business and personal finances separate.
Depending on your lender, you may also need to provide some or all of the following during the application process:
Business plan: Many lenders want to know in detail why your business needs the loan you’re applying for. Prepare a detailed business plan outlining the purpose of the loan, including business objectives, market analysis, and financial projections. It's often a good idea to consult with an accountant or business consultant for guidance with this.
Financial statements: Some financial institutions want comprehensive financial information including projections on annual revenues and cash flow going forward together with your business and personal tax returns, balance sheet statements, business credit card statements, bank statements, and income statements. Some banks now want to be able to link to your business checking account and accounting software to check real-time revenues and transaction volumes during the application process.
Collateral: Collateral are personal and business assets that your lender may seize and sell off if your business fails to adhere to the repayment terms of your facility. The amount of collateral you offer must be equal to or more than the value of the loan amount you’re applying for.
Down payment: Some loans require an upfront lump-sum deposit payment, just like the deposit on a residential mortgage. You may pay interest at a lower rate if you offer a bigger deposit.
Personal guarantee: Borrowers might have to sign a guarantee that they’ll be personally responsible for repaying any outstanding balance on a loan that’s gone into default. If you offer collateral, your lender sells it, and it doesn’t cover the outstanding balance, the lender can require you to repay the remaining balance.
Step 4: Prepare and Submit Your Application
The next stage of the loan process is to apply. There are generally three steps in this part of the process:
Prepare and submit your application: Answer all the questions, fill out all of the forms your lender requires, and attach any additional documentation they request. Missing paperwork or incomplete sections will delay the process.
Wait for a decision: After you've submitted your application, now the lender reviews it. Be prepared because, during your wait, they may come back with additional questions they need you to answer. How long it takes your lender to make a decision will vary.
Close on your loan: If you’ve met all the qualifying criteria, your lender will send you a loan agreement. Review it, and make sure you understand what you’re committing to before you sign.
Step 5: Receive Your Funding and Repay Your Loan
The loan disbursement process is next. Depending on your lender, it can be a few hours to several days before you get your money. Loans can be disbursed in various ways from direct deposit into a checking account to wire transfers.
Be sure to familiarize yourself with the repayment terms. Some loans have monthly payments while other types of funding might have weekly or daily repayments. Consider setting up auto-pay so there’s no chance of forgetting to make a payment.
Be Prepared Whenever You Apply for a Loan
Learning how business loans work is key to improving your chances of getting the funding you need. When you’ve chosen the type of finance you need, it’s now your job to find the right lender and provide them with the reassurance they need to approve your application.
As an established online lender, Backd understands that time is of the essence when you need funding. We want to give you a fast and fuss-free experience with same-day decisions and funds within 24 hours. You can apply for one of the following funding options:
A business line of credit offering up to $750,000
A working capital advance offering up to $2 million
Apply in just three minutes today to get the financing you need.