How to Choose the Best Business Loan

Running a business takes a lot of money. Sometimes, even successful businesses need extra cash to grow, expand, or just keep things running smoothly. That’s where business loans come in. But with so many different types of loans and lenders out there, how do you choose the best one for your business? In this guide, we’ll walk you through everything you need to know to make an informed decision.

Understanding Your Business Loan Needs

Before you start applying for loans, it’s important to understand your specific needs. What do you need the money for? How much do you need? And how quickly do you need it? Answering these questions will help you narrow down your options and find the best loan for your business.

What Type of Business Loan Do You Need?

There are many different types of business loans, each designed for a specific purpose. Here are a few common ones:

Startup Loans vs. Expansion Loans vs. Working Capital Loans

Startup loans are for new businesses that need money to get off the ground. These loans can be harder to qualify for because lenders consider startups to be riskier.

Expansion loans are for established businesses that want to grow. This could mean opening a new location, buying more equipment, or hiring more staff.

Working capital loans are for businesses that need money to cover day-to-day expenses, like payroll, rent, and utilities. These loans are usually short-term and can help you get through a slow season or an unexpected expense.

If you’re not sure what type of loan you need, you might want to check out our loans pillar page for more information.

Short-Term vs. Long-Term Loans: Which is Right?

Short-term loans are typically for smaller amounts and have to be repaid within a year or two. They’re great for covering immediate needs but usually come with higher interest rates.

Long-term loans are for larger amounts and can be repaid over several years. They’re ideal for big investments, like buying real estate or equipment, and often have lower interest rates.

Assessing Your Financial Readiness

Before a lender will give you a loan, they’ll want to see that you’re financially responsible. Here’s what you need to know:

Credit Score Requirements and How to Improve Yours

Your credit score is a number that represents your creditworthiness. The higher your score, the more likely you are to get approved for a loan and get a good interest rate.

Most lenders look for a credit score of at least 680, but some may accept lower scores. If your score is low, you can improve it by paying your bills on time, paying down debt, and correcting any errors on your credit report.

Debt-to-Income Ratio and Its Impact

Your debt-to-income ratio (DTI) is the percentage of your monthly income that goes toward paying debt. Lenders use this number to see if you can handle more debt.

A lower DTI is better. To calculate your DTI, add up all your monthly debt payments (like rent, car loans, and credit card payments) and divide that by your monthly income. Multiply by 100 to get a percentage.

Financial Statements: What Lenders Want to See (P&L, Balance Sheet, Cash Flow)

Lenders will also want to see your financial statements, including:

• Profit and Loss (P&L) Statement: Shows your revenue and expenses over a period of time.
• Balance Sheet: Shows your assets, liabilities, and equity at a specific point in time.
• Cash Flow Statement: Shows how much cash is coming in and going out of your business.

These documents help lenders understand your business’s financial health and your ability to repay the loan.

Exploring Business Loan Options

Now that you understand your needs and financial readiness, let’s explore some of the different loan options available.

Small Business Administration (SBA) Loans

The Small Business Administration (SBA) offers several loan programs designed to help small businesses. Here are a few of the most common:

7(a) Loans: Overview and Benefits

7(a) loans are the SBA’s most popular loan program. They can be used for a variety of purposes, including working capital, buying equipment, or refinancing debt.

Benefits of 7(a) loans include:

• Loan amounts up to $5 million.
• Long repayment terms (up to 25 years for real estate, 10 years for equipment, and 7 years for working capital).
• Lower down payments (typically 10-20%).
• Competitive interest rates.

504 Loans: For Real Estate and Equipment

504 loans are specifically for buying real estate or equipment. These loans are designed to help businesses grow and create jobs.

Benefits of 504 loans include:

• Loan amounts up to $5 million.
• Long repayment terms (10, 20, or 25 years).
• Fixed interest rates.
• Low down payments (typically 10%).

Microloans: For Smaller Funding Needs

Microloans are for businesses that need a smaller amount of money, usually up to $50,000. These loans can be used for working capital, inventory, or equipment.

Benefits of microloans include:

• Smaller loan amounts, which can be easier to qualify for.
• Shorter repayment terms (up to 6 years).
• No collateral required for some loans.

Term Loans

Term loans are a common type of business loan. They’re usually for a specific amount and have a fixed repayment schedule.

What are Term Loans and How Do They Work?

With a term loan, you borrow a lump sum of money and repay it over a set period of time, with interest. The repayment period can be short (a few months) or long (several years).

Term loans are good for:

• Buying equipment or inventory.
• Expanding your business.
• Refinancing debt.

Fixed vs. Variable Interest Rates

Term loans can have either fixed or variable interest rates.

Fixed rates stay the same for the life of the loan. This makes your monthly payments predictable.

Variable rates can change over time, based on market conditions. This means your payments could go up or down.

Repayment Schedules and Options

Most term loans have a fixed repayment schedule, where you make the same payment every month. Some loans, however, offer flexible repayment options, like interest-only payments for a period of time.

Business Lines of Credit

A business line of credit is like a credit card for your business. You can borrow up to a certain limit and only pay interest on the amount you use.

How Lines of Credit Differ from Term Loans

With a line of credit, you can draw money as needed, up to your credit limit. You only pay interest on the amount you borrow. This is different from a term loan, where you get a lump sum and start paying interest on the whole amount right away.

For more information on how lines of credit work, check out our personal loans page.

Ideal Use Cases for a Business Line of Credit

Lines of credit are great for:

• Managing cash flow.
• Covering unexpected expenses.
• Taking advantage of business opportunities quickly.

Equipment Financing

If you need to buy equipment for your business, equipment financing can help.

Specifics of Equipment Loans

With an equipment loan, the equipment you’re buying serves as collateral. This means the lender can repossess the equipment if you don’t make your payments.

Equipment loans are usually easier to qualify for than other types of loans because the equipment is collateral.

Leasing vs. Buying: Which is More Cost-Effective?

You can also lease equipment instead of buying it. Leasing can be a good option if you need the latest technology or if you don’t have the cash to buy outright.

However, buying is usually cheaper in the long run because you own the equipment at the end of the loan.

Invoice Financing & Factoring

If your business has unpaid invoices, you can use them to get a loan.

How Invoice Financing Works

With invoice financing, you use your unpaid invoices as collateral to get a loan. The lender gives you a percentage of the invoice amount upfront (usually 80-90%) and the rest when your customer pays.

Pros and Cons of Factoring

Factoring is similar to invoice financing, but instead of using your invoices as collateral, you sell them to a factoring company. The factoring company collects the money from your customers.

Pros of factoring:

• Quick access to cash.
• No collateral needed (other than the invoices).

Cons of factoring:

• You get less than the full invoice amount.
• The factoring company interacts with your customers.

Merchant Cash Advances (MCA)

A merchant cash advance (MCA) is a type of financing where you get a lump sum in exchange for a percentage of your future sales.

Understanding MCAs and Their High Costs

MCAs are easy to get, but they come with very high costs. The factor rate (similar to an interest rate) can be as high as 50% or more.

Only consider an MCA if you’re desperate and have no other options.

When MCAs Might Be Considered (and When to Avoid)

MCAs can be useful if:

• You have bad credit and can’t get a traditional loan.
• You need money quickly.

But you should avoid MCAs if:

• You have other loan options.
• You can’t afford the high costs.

Alternative Lending Platforms (Online Lenders)

Online lenders offer a convenient way to get a business loan. They’re often faster and easier to qualify for than traditional banks.

Pros and Cons of Online Lenders

Pros of online lenders:

• Fast application and approval process.
• More flexible requirements.
• Can be a good option for businesses with less-than-perfect credit.

Cons of online lenders:

• Higher interest rates.
• Less personalized service.

Comparison Table: Online Lenders vs. Traditional Banks

Comparing Loan Terms and Rates

Once you’ve found a few loan options, it’s time to compare them. Here’s what to look for:

Interest Rates: Fixed vs. Variable, APR Explained

Interest rates can be fixed or variable. Fixed rates stay the same, while variable rates can change.

APR (Annual Percentage Rate) is the total cost of the loan, including interest and fees, expressed as a yearly rate. It’s a good way to compare loans.

Fees and Charges to Watch Out For (Origination Fees, Prepayment Penalties, etc.)

Watch out for fees like:

• Origination fees: A fee charged by the lender to process the loan.
• Prepayment penalties: A fee for paying off the loan early.
• Late fees: A fee for missing a payment.

Loan Terms: Impact on Monthly Payments and Total Cost

The loan term is how long you have to repay the loan. Longer terms mean lower monthly payments but more interest paid over time.

Comparing Offers: Using Loan Calculators

Loan calculators can help you estimate your monthly payments and total cost. Here’s a loan calculator you can use.

The Application Process

Once you’ve chosen a loan, it’s time to apply. Here’s what you need to know:

Gathering Required Documents

Lenders will ask for documents like:

• Business plan: A detailed plan explaining your business and how you’ll use the loan.
• Tax returns: Personal and business tax returns for the past few years.
• Bank statements: To show your cash flow.

Business Plan (Importance and What to Include)

Your business plan should include:

• Executive summary.
• Company description.
• Market analysis.
• Organization and management structure.
• Service or product line.
• Marketing and sales strategy.
• Financial projections.

Tax Returns (Personal and Business)

Lenders will want to see your tax returns to verify your income and business profitability.

Bank Statements

Bank statements show your cash flow and help lenders see if you can afford the loan payments.

Submitting Your Application

Submit your application online or in person, depending on the lender. Make sure you provide all the required documents.

The Underwriting Process

During underwriting, the lender will review your application and documents. They may ask for more information or clarification.

Closing the Loan

If your loan is approved, you’ll sign the loan agreement and get the money. Make sure you understand all the terms before signing.

Avoiding Common Pitfalls

Getting a business loan can be tricky. Here’s how to avoid common mistakes:

Predatory Lending Practices

Watch out for lenders who:

• Charge extremely high interest rates.
• Have hidden fees.
• Pressure you into signing.

Understanding Loan Agreements (Read the Fine Print!)

Always read the loan agreement carefully. Make sure you understand:

• The interest rate.
• Fees.
• Repayment terms.
• Any penalties.

Overborrowing: Calculating What You Can Afford

Don’t borrow more than you need or can afford to repay. Use a loan calculator to estimate your payments and make sure they fit into your budget.

FAQ

What’s the difference between APR and interest rate?

APR (Annual Percentage Rate) includes the interest rate plus any fees, so it gives you a better idea of the total cost of the loan. The interest rate is just the cost of borrowing the money.

How much will I need for a down payment?

Down payments vary depending on the loan type and lender. Some loans require no down payment, while others may require 10-20% or more.

Can I get a business loan with bad credit?

Yes, but it will be harder. You may need to provide collateral or pay higher interest rates. Online lenders and microloans are good options for bad credit.

What happens if I can’t repay my business loan?

If you can’t repay your loan, the lender may take collateral (if the loan is secured) or take legal action against you. It’s important to communicate with your lender if you’re having trouble making payments.

How long does it take to get approved for a business loan?

It depends on the lender and loan type. Online lenders can approve loans in a few days, while traditional banks may take weeks or months.

Key Takeaways

• Define your business’s financial needs clearly. Understand why you need the loan and how much you need.
• Shop around and compare offers from multiple lenders. Look at interest rates, fees, and terms.
• Understand all loan terms and fees before signing. Read the fine print.
• Be realistic about your repayment ability. Don’t borrow more than you can afford to repay.
• Don’t be afraid to seek professional financial advice. A financial advisor can help you make the best decision.

Securing Your Business’s Future

Taking out a business loan is a big decision. It can help you grow your business and achieve your goals, but it also comes with risks. By understanding your options, comparing loans, and borrowing responsibly, you can secure your business’s financial future.

For more information on loans and financial management, check out our personal loan rates, compare personal loans, debt consolidation loans, student loan refinance, auto loan rates, and heloc vs home equity loan pages.