Having a good idea plays an important role in being a successful entrepreneur and small business owner, but it's not the only requirement. Unless you have the means to self-fund, the first step is to secure a loan. But do you know how to choose the best one for your needs and objectives?
The most common types of business loans
If you don't have any experience in the world of financing, then you probably don't realize that there are many different types of loans. In fact, there are enough different loan types and formats to make your head spin. Before we dig into some tips and tricks for evaluating and choosing the right loan, let's take a brief look at two of the most common types of loans, as well as the individual funding options within each category.
1. Small Business Administration loans
The Small Business Administration (SBA) offers different types of loans specifically designed for small business owners who meet certain requirements and qualifications. Here are the four major types:
7(a) Loan Program
By far the most basic and popular loan the SBA offers is the 7(a) loan program. These loans can be used for a variety of things, including working capital, to purchase real estate, acquire or expand and even to refinance existing debt.
Pros
- Long repayment time (up to 10 years)
- No collateral requirements
- Lower-than-average interest rates
Cons
- Difficult qualification process
- Very specific documentation requirements
- Personal guarantee
Microloan program
For brand new or growing businesses, the SBA offers small loans in the form of microloans. These loans can be used for many of the same things a 7(a) loan can be used for; they just come in a smaller amount and shorter repayment terms. The average loan is $13,000, and the maximum repayment term is six years.
Pros
- Very quick distribution (generally 30 days)
- Lends to businesses that traditional lenders won't work with
- Used on a variety of business costs (inventory, machinery, working capital, etc.)
Cons
- Two layers of bureaucracy (government and bank)
- Spending restrictions (can't buy real estate or pay off debt)
CDC/504 Loan Program
This loan program gives businesses a long-term fixed rate for major assets like real estate and equipment. The SBA generally provides 40% of the loan, while an approved lender covers as much as 50%. The borrower then has to put up the remaining percentage. The maximum 504 loan is $5.5 million, and details are negotiable to include 10- or 20-year maturity terms.
Pros
- Affordable fixed interest rates
- Very large loan amounts
- Easy qualification process
Cons
- Strict usage restrictions
- Must be used to create jobs (one job per $65,000)
- Must be able to cover 10% of loan on your own
Disaster loans
Finally, there are SBA disaster loans. These loans – which max out at $2 million – can be used to purchase, repair or replace assets that were destroyed as part of a declared disaster.
Pros
- Higher-than-average maximum loan amount (up to $2 million)
- Lenient terms (up to 30 years for repayment)
- Flexible usage of funds
Cons
- Very challenging qualification process
- Affordability depends on other financing options available
- Must be located in a disaster zone
Editor's note: Looking for a financing solution for your business? If you're looking for information to help you choose the one that's right for you, use the questionnaire below to get information from a variety of lenders for free:
2. Traditional loans
SBA loans are great … if you qualify. However, for people who don't meet the requirements or need something more flexible, traditional loans offer even more opportunities. Here are some different types of traditional loans.
Equipment loan financing
A lot of small businesses simply need a loan for equipment. With an equipment loan, you can purchase anything from tablets for your employees to new machinery in the warehouse and make monthly payments on the items, as opposed to having to fork over all of the cash at once.
Pros
- Very flexible terms
- Fast funding
- No additional collateral (beyond equipment)
Cons
- Restricted to equipment
- Requires equipment purchasing (no leasing)
- Higher-than-average interest rates
Line of credit
If your business is more unpredictable and you need cash some months but not other months, a line of credit is perfect. It just sits there until you need it, and you only have to take out the amount that you need.
Pros
- Only pay for what you use
- Helps balance cash flow during slower periods
- Encourages flexibility
- Helps companies boost business credit score
Cons
- Strict qualification requirements
- Lots of additional fees and charges
- Limited borrowing power
Working capital loan
For lots of small businesses, the cyclical nature of revenue means there are some months when there isn't enough money to keep the lights on. A working capital loan is a short-term solution that enables you to temporarily infuse cash into your business while you find ways to bring in more revenue.
Pros
- Always have cash on hand
- Few (if any) spending restrictions
- No need to put up collateral (if the business has good credit)
Cons
- Higher-than-average interest rates
- Fast repayment requirements
Merchant cash advance
If you run a small business where you get lots of credit card transactions, a merchant cash advance can help keep money flowing. This type of loan is based on the volume of your monthly transactions and gives you an advance of up to 125% of your anticipated volume. You then steadily repay it over the next month with specific terms.
Pros
- Easy to qualify for
- Fast funding
Cons
- Lots of contingencies
- Higher-than-average fees
Invoice factoring
Invoice factoring is a unique way of increasing cash within your business by leveraging money that's already owed to your business. It works like this: You sell any outstanding invoices you have to a factoring company in return for a lump sum (usually 70 to 90% of the total amount). You're then able to use this cash as you see fit.
Pros
- Immediate cash
- No collateral
- Flexible use of funds
- Easy approval
Cons
- Expensive (reduces profits by 10 to 30%)
- Liability (can be responsible for unpaid invoices)
Business credit cards
In some cases, a simple business credit card can be used like a line of credit to fund business purchases. However, much like personal credit cards, business credit must be used with extreme caution and discipline; otherwise, costs get out of hand.
Pros
- Easy and simple qualification
- Rewards and perks for using credit card
- Only pay for what you use
Cons
- Very high interest rates
- Minimal purchasing protection
- Possibility of security/fraud issues
Secured loans
A secured business loan is very much a traditional loan in the sense that it's backed by an asset, such as a building, land or equipment. If you're unable to make payments, the collateral can be seized by the lender to offset the money owed.
Pros
- Low interest rates
- Easy to obtain
- Generous repayment terms (as much as 20 or 30 years)
Cons
- Risk of losing the asset
- Requires a certain type of asset for approval
- Only for established businesses (not ideal for startups)
Unsecured loans
An unsecured loan is the opposite of a secured loan in the sense that no collateral is required. This poses less risk for the business, but it also means you offset the risk in other ways – such as higher interest rates.
Pros
- No risk of losing your property
- Shorter-than-average loan application process
Cons
- Meticulous qualification process
- Higher interest rates
- Lower loan amounts
Term loans
A term loan is a very basic type of loan that operates much in the same way as a student loan or home mortgage. The business borrows a lump sum upfront and is then required to repay it in weekly or monthly installments over a predetermined period of time.
Pros
- Quick processing
- Lower interest rates
- High loan limits
- Simple budgeting
Cons
- Personal guarantee required (in most cases)
- High credit score needed
- Demonstrated profitability preferred
- Financing fees
Personal loans
While it's not always the first option business owners pursue, personal loans can be used for business purchases and expenses (so long as the lender doesn't have restrictions that state otherwise). Personal loans are considered unsecured debt and are widely used for a variety of purposes.
Pros
- Extremely versatile
- Decent interest rates
- Lots of options for lenders (including peer-to-peer online lenders)
Cons
- Origination fees
- Penalties for paying off early (in some cases)
- Restrictions for business use
4 tips for evaluating and choosing the right loan
Is your head spinning yet? Those were just a few examples of small business loans – many more exist. Here are some recommendations for choosing the right loan for your situation.
1. Become more self-aware.
Before you do anything else, spend time evaluating your business and how lenders see you. A quick credit check will help you understand your score, which is one factor involved, but you also need to know your debt-to-equity ratio.
According to business consultant David Duryee, this is one of the most important metrics a lender analyzes. "It is a basic financial principle that the more you rely on debt versus equity to finance your business, the more risk you face," he explains. "Therefore, the higher the debt-to-equity ratio, the less safe your business [is]."
2. Consider the interest rate.
You obviously want to consider the interest rate, though this shouldn't be the only determining factor. For example, if a $100,000 loan has repayment terms of five years, a difference of two percentage points really doesn't matter that much in the grand scheme of things. It would, however, matter if the loan were for $1 million spread out over 20 years. Be smart about comparing interest rates, and give more weight to it when terms are higher.
3. Look at repayment terms.
Speaking of repayment terms, what is the length of time? What does the payment schedule look like? Can you pay off the loan early, or do you have to wait until maturation? It's easy for these to seem like small little details in the fine print of a loan, but they can save or cost you tens of thousands of dollars when it's all said and done.
4. Consider application fees.
Are you aware that some lenders actually require you to pay in order to submit an application, while others don't?
"It is important to ask what types of fees are associated with the application," Business News Daily advises. "Some lenders charge an application fee, while others charge fees for items tied into the application, such as the cost to run your credit report or get your collateral appraised."
Take your time
You may feel like you have time against you, but it's OK to slow down a bit. The absolute worst thing you can do is rush into this. Prematurely selecting a loan, only to figure out a month from now that you chose the wrong one, can be devastating to your business. Be patient and carefully evaluate all of your options before proceeding too far in the process.
Related Articles For Business Loans: How to Choose the Best Business Loan
Best Business Loan Comparison Guide - Business.com
Looking for the best small business loan service? We have expert reviews and feature comparisons of the top business loan providers.
What Government Loans are Available to Entrepreneurs? - Business.com
Several loan programs are available to startups and growing businesses, as we found when we went looking for an answer to Business.com user Jenny Simon's question.
How to Start a Business Without a Loan? - Business.com
Debt isn't the only way! Here are alternatives to getting a loan in order to start your business.