For most companies, business loans are an essential part of doing business. Knowing how to borrow efficiently and cost-effectively can make a difference to your bottom line and possibly the survival of your enterprise.
Think of business loans like financial tools. You need to know how to match the right tool to your specific situation, which might include:
- Starting a business
- Expanding a business
- Managing cash flow
Some loans are clearly more effective tools for these situations than others. And it’s important to know all your options before choosing. This guide to business loans can serve as a reference to help you choose a business loan based on your situation.
Sources of business loans
Understand that you can have multiple potential sources of credit. Being open minded about sources may allow you to find better credit terms.
- Traditional banks
- Online banks
- Non-bank lenders
- Credit card companies
Keep your future credit needs in mind when deciding where to deposit your company’s cash and do other corporate finance business. Building a broad, ongoing relationship with a financial institution may help when it ‘s time to ask for a loan.
Image courtesy of the SBA
Best types of business loans for start-ups
Getting off the ground is the toughest part of a business life cycle. Having adequate funding is a key part of making it work. This is more than just financing a place to set up shop, advertising, and buying equipment and initial inventory. Start-up financing should be adequate to cover several months of ongoing operations while you wait for revenues to ramp up.
Many businesses fail because of inadequate or the wrong type of funding. Here are some types of business loans that can help prevent that from happening.
Personal loan
For a new business with no credit history or revenues, a personal loan might be the best shot at getting start-up funding. Personal loans are exactly that — personal. That means the business owner, not the business, guarantees the loan.
Most personal loans are unsecured. Unsecured financing approval depends a great deal on your credit score and current sources of income. Often it can help to work with a local institution — banks and credit unions often have an active interest in promoting local business activity.
If your credit score is not great, you may need to secure a personal loan with collateral. That means assets owned by you or your business that the lender can repossess if you don’t repay the loan.
Before you apply for a personal loan to start a business, check your credit report. Make sure there are no mistakes or other issues that can be readily addressed to raise your credit score. Also, knowing your score allows you to start shopping for the best loan terms available to you.
When you shop for a personal loan, compare terms being offered to someone with your credit score and other qualifications. Lenders prominently advertise their best rates, but unless you have an excellent credit history and a strong financial situation, you will probably have to settle for less attractive terms.
While a personal loan can be a pragmatic way to start your business, it may not be the best way to run your business. Once your business has established its own financial track record, get credit guaranteed by the company and limit your personal liability.
Summary:
- Best fit for new businesses started by people with a good credit history
- Not as attractive for established businesses or start-ups owned by someone with poor credit
Related: Personal Loan Interest Rates (And How to Pay Less)
Rollover for Business Startups (ROBS)
Another way of using personal credit to start a business to use a Rollover for Business Startups (ROBS) loan. This entails borrowing against your balance in a 401(k), IRA or other self-directed retirement plan.
To do this, you set up a 401(k) plan for the new company you are starting, and roll the balance from an existing retirement plan into the new plan. You then borrow against your balance in the new plan. This has to be done formally and according to IRS laws. Or it may be considered a withdrawal from the plan and cost you taxes and penalties.
Most company-sponsored plans do not allow current employees to roll money out. So, you are most likely to be able to set up a ROBS loan if you have a large balance at a prior employer, or if you have money in an IRA.
The new company you set up must be a C corporation. As a practical matter, this works best if you have a substantial retirement plan balance to borrow against. That’s because the costs of administering a 401(k) plan and the ROBS loan itself could be prohibitive if you were just borrowing a few thousand dollars.
The risks of using a ROBS loan are two-fold. First, you could slow the investment growth of your retirement savings or jeopardize them altogether by borrowing against them. Second, if you are unable to pay back the loan on schedule, the loan is likely to be deemed a withdrawal from the retirement plan. The amount you fail to pay back would also be subject to a taxation and probably a 10% penalty if you are younger than 591/2.
Summary:
- Best fit for business owners with a substantial balance in a retirement plan
- Not as attractive for small loans
Franchise loan
Many business startups are franchises of national organizations. A good franchise provides support for its business owners in a number of ways, and one way may be financing.
To start a franchise. you are likely to have to meet certain qualifications. And this will certainly be true if the parent organization is providing financing. So, even though it is a business loan, your personal creditworthiness is likely to be a factor, as are your business qualifications.
A franchise loan can give you an inside track to qualifying for credit. However, you should still compare the credit terms to other alternatives. Providing credit might be one of the ways the parent company makes money. The loan terms may be designed more for the profit of their company than yours.
Summary:
- Best fit for franchise startups with strong owner-support structures
- Not an option for non-franchise businesses
Unsecured loan
Whether you finance your business with a personal loan or a business loan, you should understand the pros and cons of secured vs. unsecured loans.
A secured loan requires you to pledge collateral to the lender. Collateral is an asset the lender can take and sell if you fail to repay your loan. Because this helps protect the lender, having collateral can help you get more favorable loan terms. An established business may have assets that can be used as collateral, but if your business is a start-up you are more likely to have to put up personal rather than company property to secure a loan.
The downside is that pledging collateral puts your personal property at risk. That’s why an unsecured loan might be a safer option. Starting a business is already risky enough. You might not want to put your personal property on the line. An unsecured loan is an especially viable option if you have a very strong credit history. And a strong credit history can allow you to qualify for favorable loan terms without having to put up collateral.
Summary:
- Best fit for people with strong credit histories
- Not as attractive for people whose credit record is too weak to qualify for a loan without collateral.
Image courtesy of the SBA
SBA 7(a) loan
The Small Business Administration (SBA) is a federal agency that guarantees business loans. That federal guarantee can help a business get approved for a loan even with little or no credit history.
Companies engaged in for-profit business in the United States are eligible. To qualify, the business owner has to have invested time and/or money in the company, and must have exhausted any other possible sources of financing. This last requirement means you should probably check out other types of loans first.
SBA loans can range from a few hundred dollars to a few million. The 7(a) loan program is the SBA’s main way of providing financing to businesses. Qualified businesses can borrow up to $5 million, though the SBAs guarantee is strongest (85 percent) for the first $150,000 of a loan. That means qualification may be easier and terms more attractive for loans that don’t exceed that amount.
Summary:
- Best fit for US companies that would otherwise have trouble securing financing
- Not an option if the company operates outside of the United States or if the owner has not put time or money into the company
SBA 504/CDC loan
The SBA has a program designed expressly for companies that want to borrow money to invest in commercial real estate. The main qualification is that the business borrowing the money has to occupy the majority of the building. You can, however, rent out a minority portion of the space to other tenants.
The SBA operates this loan program by matching private lenders with CDCs, which are Certified Development Companies. CDCs are not-for-profit companies that lend money as a means of promoting local job growth. Willingness to invest in the local business community could make the difference when securing credit for a fledgling company.
Summary:
- Best fit for companies looking to buy real estate as space for business operations
- Not an option for purposes other than investing in operating space
SBA microloan
The SBA has a microloan program designed to promote lending to very small businesses. This program works through non-profit lending organizations, which make loans of amounts up to $50,000. Unlike other SBA loans, the SBA does not guarantee these microloans. They lend to the non-profit lenders, which provide capital for business microloans.
An SBA microloan might be an especially viable way for a business starting up in an under-served community to secure initial financing. The non-profit organizations that make these loans often also provide training and technical assistance to help support the business.
Summary:
- Best fit for very small businesses in communities with non-profit lenders whose mission it is to promote local business conditions
- Not an option for amounts in excess of $50,000
Not-for-profit business loan programs
SBA microloans are not the only programs available through non-profit lenders. Various states, cities and philanthropic organizations have economic development programs. And these include lending to small businesses.
The application process for this type of loan may be more exhaustive than for an ordinary business loan. That’s because these organizations consider the potential impact of your business on the community. However, if you have found other sources of credit unavailable, a not-for-profit loan program might be the lifeline you need to start your business.
Summary:
- Best fit for small businesses in under-served communities that are targeted for help by not-for-profit loan programs.
- Not as likely an option for businesses seeking large loans
Related: Create Emergency “Savings” With a Personal Line of Credit
Best types of business loans for expansion
Suppose your business is up and running, and you’ve seen some success. Now it’s time to expand. The problem is that expansion may require an investment that is beyond the means of your year-to-year business receipts. This is when you should choose a business loan geared towards the type of investment in plant or equipment you are about to make.
Commercial mortgage loan
As a business owner, one of the decisions you are likely to face at some point is whether to lease or own your business quarters. Many businesses start out leasing, but then migrate to ownership as their needs become more extensive and more specialized.
If you decide to buy your business quarters, a commercial real estate loan is the best option. This works similarly to a home mortgage in that the loan is secured by the the property. Putting up that property as collateral makes a commercial mortgage easier and less expensive to obtain than other kinds of financing.
As with a home mortgage, the value of the property is a factor in getting approved for a commercial mortgage. The lender orders a property appraisal to make sure that the sales price is realistic. And that it can recoup the loan amount by foreclosing if necessary. The maximum loan amount will be some percentage of the lower of the property appraised value or the sales price.
Commercial mortgage lenders generally focus on the credit history and revenues of the business rather than on your personal finances. So, it helps if your business has at least a couple years of profitable operation under its belt before you apply for a commercial mortgage loan.
Summary:
- Best fit for established, profitable businesses looking to invest in real estate for their business operations
- Not an option for most start-ups, businesses struggling with profitability or loans for non-real estate purposes
Equipment loan
Business often have to spend massive amounts on equipment, from computers to production machinery to vehicles. While these are very costly investments, the advantage is that you can use them to secure a loan.
As with a commercial mortgage, loans secured by equipment usually come with easier approvals and cheaper financing terms. From a cash flow standpoint, one key is being able to plan ahead to see if you can operate profitably even while you are making the loan payments. Another is making sure the term of the loan is shorter than the useful life of the equipment, so you are not continuing to pay for equipment you can no longer use.
A convenient thing about an equipment loan is that many vendors of business equipment will arrange financing for you. While this can be helpful, don’t accept the vendor’s financing terms unless you have researched outside options as well. You may not get the best terms if a vendor views you as something of a captive audience.
Summary:
- Best fit for established, profitable businesses looking to make long-term investments in equipment
- Not an option for buying things that don’t have lasting value as a business asset
Installment loan
Mortgage loans and equipment loans are examples of loans for specific purposes. Whatever the purpose, there are different loan structures available that can be tailored to your situation.
The most common type of loan is an installment loan, which is repaid in fixed amounts over a specified period of time. With an installment loan, you you pay down the principal over time until the balance is zero. This process, called amortization, means that you pay more interest at the beginning of the loan, when the balance is higher. As the balance falls, you pay less interest. Each payment reduces the balance more and more until it reaches zero.
One positive of an installment loan is that those uniform payments make it easier to plan your cash flow. On the other hand, installment loans can create an initial cash flow challenge when the purpose of the loan is to expand your business. An expansion designed to grow your revenues might pay off in the later years of the loan. However, having constant payments throughout the loan term could make the initial payments more challenging — when the benefits of expansion have yet to be realized.
Summary:
- Best fit for companies with ample cash flow looking to minimize the overall interest expense of financing
- Not as attractive for companies looking to minimize the near-term cost of expansion due to tight cash flow
Balloon loan
In contrast to the even payments of an installment loan, a balloon loan features smaller payments in the early years of the loan, followed by a large (or “balloon”) payment towards the end of the loan.
This kind of loan can be a good fit for expansions because they allow you to make smaller payments until growth has a chance to kick in. On the downside, because you aren’t paying off principal as steadily as you would with an installment loan, your total interest expense is usually higher.
Also, while a balloon loan makes your cash flow situation easier in the short-term, you have to plan ahead and make sure you build up enough cash before the balloon payment comes due.
- Best fit for a specific, long-term plan to build revenue through investment in expansion
- Not as attractive for companies with strong current cash flow looking to minimize long-term interest expense.
Hard money loan
A hard money loan is a secured loan made by a private investor rather than by a traditional lender. These investors are more concerned with the value of the asset securing the loan than with the finances of the borrower. The advantage to that is making investment in expansion possible to businesses that haven’t had a chance to build up a substantial positive cash flow history.
There are drawbacks to hard money loans. They typically involve more expensive terms than a loan from a traditional lender. Also, investors who make hard money loans protect themselves by lending for relatively short periods and typically limiting their loans to between 50 and 70 percent of the value of the asset used to secure the loan.
Summary:
- Best fit for companies looking for financing more quickly than would be available through traditional channels
- Not as attractive for companies that lack the resources to put up a substantial portion of the expansion investment themselves, or to pay off the loan at an accelerated pace due to the shorter loan term
Related: Good Debt, Bad Debt (When Personal Loans Are a Good Choice)
Best types of business loans for managing cash flow
While startups and expansion are all about growth, managing cash flow is a key to the long-term stability of your business. The challenge is that the timing of revenues and expenses do not always match up neatly, but some loans can help smooth out the timing by making capital more regularly available.
Business credit card
This is a staple for most businesses. It enables the company to meet day-to-day expenses without getting held up by a loan approval process or even the time it takes to approve and cut a check internally.
While the plus side of a business credit card is immediacy and convenience, the downside is the cost. Credit card rates are generally more expensive than loan rates, so the goal should be to avoid carrying a long-term credit card balance. If your company can pay off its credit card balance from month to month, you can use the benefits of this tool without incurring the greater expense.
Getting a business credit card is likely to depend on the company’s having built up a solid credit and cash flow history. So this is a better option for companies that have had a chance to establish themselves.
Summary:
- Best fit for established companies with good credit
- Not as attractive for newer companies or those with shaky cash flow
Line of credit
A line of credit is a pledge from a lender to make up to a certain amount of credit available to you on demand for a certain period of time, subject to agreed-upon terms.
The primary advantage of a line of credit is that you only pay interest on the amount you use. It’s flexible. However, there may be a setup costs for a line of credit, so you don’t simply want to have one unless you intend to use it.
The flexibility of a line of credit can be ideal for businesses that are actively seeking acquisitions, but can’t predict exactly what the timing of those deals might be.
Summary:
- Best fit for established companies with active investment plans that have uncertain timing
- Not as attractive for companies without specific credit needs
Letter of credit
A letter of credit is a guarantee from a bank to provide payment on behalf of a business once the terms of a deal have have been satisfied. This mode of financing is commonly used for companies making purchases from non-US vendors with whom they have not yet established a relationship.
Essentially, when buyers and sellers of goods don’t know each other and are dealing internationally, the bank’s role in providing a letter of credit is to act as a third party the buyer and seller can both trust. This can facilitate transactions and over time help a company establish relationships with foreign vendors.
A bank is only likely to provide a letter of credit on behalf of a trusted customer, which may entail having a well-established relationship with the bank. And possibly a substantial amount of money on deposit.
Summary:
- Best fit for businesses with established banking relationship looking to forge new international supplier relationships
- Not as attractive for newer companies or those not interested in doing business internationally
Short-term loan
Short-term loans, bridge loans and interim loans are all similar forms of the same type of credit. They provide cash quickly, which can help to initiate a deal until longer-term financing can be arranged.
While these loans deliver quick approval, they typically carry very short repayment terms and higher expenses. Pay particular attention to fees and closing costs. On a shorter-term loan, those expenses are effectively amortized over a shorter period of time and thus represent a higher percentage cost.
Short-term loans play a role somewhere between a business credit card and more conventional business loans. They may allow for somewhat larger amounts and longer repayment terms than you would generally use a credit card for, but they are more immediate than most loans. With the downside being the cost, the idea is to use these only to fill occasional gaps in financing rather than as credit to be routinely rolled over to fund the day-to-day operations of the business.
Summary:
- Best fit for companies needing temporary financing before more cost-effective options become available
- Not as attractive for companies with longer-term or ongoing financing needs
Factoring
Though not strictly a loan, factoring belongs in this discussion because it is a form of financing commonly used to manage cash flows.
With factoring, you sell your company’s account receivables to a factoring company at a substantial discount. You get the immediate cash, while the factoring company is then entitled to collect the full value of receivables from your customers.
Factoring companies are likely to pay only 80 to 95 percent of the value of your receivables (depending on their perceived payment reliability). So if you employ factoring, you essentially trade money for time. You get your money sooner, but you receive less than the full value of your invoices.
Summary:
- Good for companies with high-volume customer transactions that also demand constant replenishment of supplies
- Not as attractive for companies with margins high enough to pay for immediate needs out of reserves rather than sacrificing some of their revenues for ready cash
Purchase order financing
Purchase order financing is a good option for companies with substantial materials costs that go into the goods they ultimately make and deliver to customers. In that scenario, the company incurs the cost of the materials well before receiving payment from the customer. This creates a potential need for financing.
Once you have a purchase order from a customer, a lender may advance you a portion of the eventual balance of that order. Your right to receive payment on the order acts as the loan security. This depends on the perceived creditworthiness of both your business and your customers.
Purchase order financing can be a useful stopgap for businesses with “lumpy” cash flows. Receipts come in large amounts, but sporadically. However, your long-term goal should be to build volume and reserves. So you can afford the materials to do business without having to incur financing costs routinely.
Summary:
- Best fit for companies making big-ticket sales requiring substantial investments in materials upfront
- Not as attractive as a long-term business strategy because it adds to the cost of materials
Merchant cash advance
A merchant cash advance is similar to factoring and purchase order financing. Like factoring, it means selling a portion of your future receipts in order to obtain cash upfront. Like purchase order financing, it is based on the value of customer purchases.
Unlike factoring, a merchant cash advance isn’t based on specific receivables. Instead, lenders consider the business’ general flow of credit card receipts. Similarly, one large purchase order doesn’t determine the loan terms. Instead, the ongoing flow of day-to-day business a company does. Thus, it is better suited to companies with a high volume of relatively small transactions.
As with purchase order financing and factoring, merchant cash advances can be a useful stopgap technique. However, as a routine means of cash flow management, they have the disadvantage of adding to your ongoing cost of doing business.
Summary:
- Best fit for high-volume businesses with short-term cash flow needs
- Not as attractive as a long-term strategy because it erodes the value of day-to-day receipts
Always compare options
The loan market is very dynamic. Interest rates change daily, underwriting standards adjust to economic conditions, and new business loan structures come and go. Even once you have a routine set up for using business credit, actively shop for the best business loan terms each time you borrow. Remember, each one of those occasions is an opportunity to improve your bottom line.
