What Is a Small Business Loan?

By: McKayla Girardin

A small business loan is a form of financing companies can use to achieve specific goals. Small businesses rely on loans from banks, credit unions, and online lenders to fund day-to-day business needs, like salaries or inventory, and large expansions or purchases, like renovating a warehouse or expanding an office space.  

In 2022, 40% of small businesses applied for a traditional loan, line of credit, or merchant cash advance, according to the Federal Reserve.   

How Do Business Loans Work?

Requirements vary by lender, but companies generally qualify for business loans based on size, income, personal and company credit profiles, and how long they’ve been operating. They receive financing as lump sums or credit lines, depending on the type of loan and lender. 

When they accept a loan, businesses agree to specific terms, including down payments, interest rates, repayment period lengths, fees, and repayment schedules. 

Additionally, a business may need to provide collateral in exchange for certain small business loans. Secured loans need collateral; unsecured loans do not. Collateral can be anything of value, such as real estate, cash, machinery, or investments. When applying for an unsecured loan, business owners might need to accept liability if they can’t repay the loan in the defined time frame. This provision is known as a personal guarantee.  

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Types of Business Loans

Bank Loan

A bank loan is often called a traditional or term loan since it’s obtained through traditional banks and must be repaid within a specific time period. While the repayment period depends on the borrower and lender, bank loans can provide short-term or long-term financing. Bank loans typically don’t have usage stipulations but come with interest rates and repayment schedules. 

SBA Loan

SBA Loans are a form of financing backed by the U.S. Small Business Administration (SBA). The SBA sets specific guidelines for who can offer or receive these loans. Since the government secures the money, lenders can extend better terms, such as lower down payments. Plus, lenders offering SBA-backed small business loans can typically lend to businesses with less-than-perfect credit histories. 

An SBA loan has a longer repayment term than most traditional loans but must be used for specific and approved purposes. Businesses have different loan options, including the 7(a) loan for expenses like working capital, partner buyouts, and refinancing commercial real estate. 

Business Line of Credit

A business line of credit works like a business credit card. A small business can open a line of credit to fund any business expenses, but the funds don’t come as a lump sum. Rather, businesses withdraw funds and make necessary purchases, and interest accumulates on those withdrawals. As businesses make payments, those funds become available again. Like with a credit card, lenders determine a business’s line of credit by reviewing its credit history. 

Equipment Financing

Equipment financing helps businesses buy machinery necessary for business operations, including vehicles, production equipment, office printers, and HVAC units. While equipment loans can’t be used for debt repayment or refinancing real estate, the definition of equipment is broad, and most tangible assets qualify. In many cases, the equipment acts as collateral for the loan. However, some lenders may require businesses to personally guarantee payment, putting themselves and their other assets at risk if they fail to repay. 

Invoice Factoring

Invoice factoring, also called invoice financing, is a way for businesses to leverage their accounts receivable invoices to receive funding. Many companies sell goods and services on credit, meaning customers don’t immediately pay the business, and an invoice is created showing when and how much the customer will pay. Sometimes, a business may need that money sooner to cover expenses like salaries, inventory, or interest payments. 

Through invoice factoring, a business can use its invoices to borrow the amount its customers will pay in the future: The lender receives the invoice and its future payment, while the business gets short-term funding. 

Merchant Cash Advance

Merchant cash advances (MCAs) allow businesses to borrow lump sums of cash in exchange for a percentage of future credit and debit card sales. Unlike a traditional loan, an MCA isn’t lending money with a promise of repayment; it’s buying a business’s future sales. MCAs are short-term funding, and usually, businesses must repay the loan in less than 24 months. However, the fees associated with MCAs are steep and can create a challenging cycle of debt. Learn more about the best cash advance lenders in your area. 

Working Capital Loans

A working capital loan is a short-term form of financing that gives businesses the money to fund daily operations. These loans need to be repaid quickly, typically in under 24 months, so they’re not meant for larger or more expensive business investments, like real estate or equipment purchases.

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Pros and Cons of Business Loans

Pros

• Financing can be used for business growth

• Competitive rates and fees for businesses with good credit

• High loan caps and long repayment terms for eligible borrowers

Getting a loan for your business can be a great way to fund both short- and long-term goals. Traditional bank and SBA loans often have reasonable interest rates and approval times, meaning you can quickly use the influx of cash to expand your business operations and pay off debts. The profits your business gains after expansion or debt consolidation are entirely yours, too. 

Cons

• Often requires collateral or personal guarantee

• High rates and fees for businesses with bad credit

• Potentially arduous application process 

With any form of financing, it’s easy to fall into a cycle of debt, particularly with less traditional forms of funding, like MCAs and invoice factoring. Additionally, it can be challenging to qualify for certain loans. If you or your business don’t have great credit or your business operates in a high-risk industry, lenders will likely only offer unfavorable loans with high interest rates. 

How to Get a Small Business Loan

Business Loan Requirements

To qualify for the best business loans, lenders will review details about you and your business, including:

• Your credit score and your business’s credit score

• How long your business has been in operation

• Your annual revenue 

• What options you have in terms of collateral, or your personal guarantee to repay the loan

• Your business plan

• Your relationship with the bank

The exact requirements vary by lender. For instance, some lenders specialize in offering loans to businesses with poor credit or early-stage companies that lack a long operating history. 

Applying for a Business Loan

When applying for a small business loan, you should:

1. Determine which type of loan is right for you. If you have long-term financing needs, a short-term option like an MCA isn’t the right fit. Additionally, consider what you intend to use the loan for. Equipment financing loans can only be used for machinery and similar tangible assets, so if you need to pay for inventory or employee salaries, consider a loan with less strict usage stipulations. 
2. Make sure you qualify. Review your and your business’s financial situation to understand which loans you can get.
3. Compare lenders. Consider factors like how quickly they disburse funds, the lender’s reputation, and whether you prefer to apply in person or online. 
4. Prepare your documentation. You’ll need to gather your business plan, bank statements for you and your business, information about previous loans, recent tax returns, available collateral, and business licenses. You may also need to describe how you plan to use the loan. 
5. File your application. The application process varies by lender and whether you seek financing online or in person. Be sure to familiarize yourself with your lender’s process beforehand.

Pro Tip: “Companies need to prepare well when applying for business loans. They must have a solid business plan and financial projections, as well as demonstrate how the loan will contribute to the growth of the company. Keeping financial records in order, understanding your credit score, and showing a history of profitability can increase the chances of approval,” says Michelle Delker, founder of The William Stanley CFO Group, a boutique fractional CFO and financial services firm.

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How to Compare Small Business Loans

Comparing your options is the best way to ensure you’re getting the perfect small business loan for your business. Consider the following factors when determining which loan is right for you: 

• Eligibility requirements. If a bank has strict credit score requirements that you can’t meet, consider other lenders. 

• Loan limits. Some lenders only offer small loan amounts. If you need a larger loan, you’ll want to prioritize lenders that can offer more substantial loan amounts. 

• Repayment periods. The shorter the repayment period, the higher your monthly payment will be. Consider how much you can afford to pay each month and how that affects the length of the loan term.

• Speed. How quickly do you need the funds? Some lenders can take up to three months to approve financing, while others may disburse funds in a few days. 

• Costs. Loans, unfortunately, aren’t free, so compare the additional costs each loan option includes, like interest rates, origination fees, down payments, and penalties for late payments. 

• Reputation. Beyond only borrowing from reputable institutions, it’s important to find a lender that has a good customer service reputation. If there’s ever an issue with your loan, talking to a helpful customer support team can make the situation significantly easier. 

Pro Tip: “In selecting the best business loan options, companies should consider their specific needs and financial situation. If a business has a strong credit history and valuable assets, a traditional bank loan might be the best option. On the other hand, a startup without a credit history might need to consider alternative financing options, like online or peer-to-peer lenders,” Delker says.

For more details on the best business loans, read our in-depth reviews of the top business lenders. 

Bio: McKayla Girardin is an experienced finance and business writer based in New York City. She is passionate about transforming complex concepts into easily digestible articles to help anyone better understand the world we live in. Her work has been featured in a number of reputable outlets, including MSN and WalletHub.  

Disclaimers

American Express® Business Line of Credit:

**All businesses are unique and are subject to approval and review.

American Express® Business Line of Credit offers two loan types, installment loans and single repayment loans for eligible borrowers. All loan term types, loan term lengths, and pricing are subject to eligibility requirements, application, and final approval. This page contains general information about the American Express® Business Line of Credit installment loan type only.

American Express® Business Line of Credit offers access to a commercial line of credit ranging from $2,000 to $250,000; however, you may be eligible for a larger line of credit based on our evaluation of your business. Each draw on the line of credit will result in either a separate installment loan or a single repayment loan. All loans are subject to credit approval and are secured by business assets. Every loan requires a personal guarantee.

For single repayment loans, we charge a total loan fee that ranges from 0.95%-1.80% of the amount you borrow for 1-month loans, 1.90%-3.75% for 2-month loans, and 2.85%-6.05% for 3- month loans. Single repayment loans incur a loan fee at origination and the principal and total loan fee are due and payable at loan maturity. There are no required monthly repayments for a single repayment loan. Repaying a single repayment loan early will not reduce the loan fee we charge you. For installment loans, we charge a total loan fee that ranges from 3-9% of the amount you borrow for 6-month loans, 6-18% for 12-month loans, 9-27% for 18-month loans, and 12-18% for 24-month loans.

Installment loans incur a portion of the total loan fee for each month you have an outstanding balance. If you repay the total of the principal of an installment loan early, you will not be required to pay loan fees that have not posted for subsequent months. For each loan that you take, you will see the applicable loan fee before you take the loan. Once you take the loan, the loan fees that apply to that loan do not change. We reserve the right to change the loan fees that we offer you for new loans at any time. American Express reserves the right to offer promotions to reduce or waive loan fees from time to time.

Not all customers will be eligible for the lowest loan fee. Not all loan term lengths are available to all customers. Eligibility is based on creditworthiness and other factors. Not all industries are eligible for American Express® Business Line of Credit. Pricing and line of credit decisions are based on the overall financial profile of you and your business, including history with American Express and other financial institutions, credit history, and other factors. Lines of credit are subject to periodic review and may change or be suspended, accompanied with or without an account closure. Late fees may be assessed.

¹The required FICO score may be higher based on your relationship with American Express, credit history, and other factors.

Loans are issued by American Express National Bank.

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*See website for average amounts by product.