A business loan is a method of debt financing for a business that involves borrowing money from a lender to be paid back over time with interest. Business loans help entrepreneurs and business owners start and grow their businesses, cover gaps in cash flow, purchase new equipment and more.
There are many different types of business loans, including term loans, SBA loans, lines of credit and other types of alternative financing. The best fit for you will depend on your loan purpose, business history and personal financial history. Business loans, also sometimes called commercial loans, are generally issued by banks, credit unions, nonprofit lending organizations or online lenders.
What are business loans used for?
Understanding the purpose of your business loan is an important part of the loan application process and will help you make the most of your funding.
Startup business expenses
Startup business expenses include things like store or office space, licenses or certifications, inventory, payroll and other purchases to help a business get off the ground.
Long-term business growth
Certain types of business purchases, such as commercial real estate, new equipment or even personnel updates, are good to finance long-term and can help your business grow over time. One of the most common types of business loans, term loans can make large purchases more affordable, and are best for long term investments to grow your business.
Short-term gaps in cash flow
A cash flow gap in business refers to the time between paying for inventory or other expenses, and when you get paid by your customer. Certain types of business models, like contractors, may be more susceptible to gaps in cash flow, and may opt for speciality financing like contractor financing or revolving funding like a line of credit or credit card.
Purchasing a business
Purchasing an existing business can be a good way to start your entrepreneurial journey without starting from complete scratch. Traditional banks and credit unions, the SBA and online lenders all offer loans to purchase a business. You may also be able to get a loan from the seller of the business.
Refinancing or consolidating business debt
Refinancing or consolidating business debt can be a good way to save money on interest and free up cash flow. With refinancing, you replace an old loan with a new one, typically one that has a lower interest rate. Consolidating debt involves combining multiple debt sources into one loan, with one monthly payment. To make the most of a refinance or consolidation loan, you’ll want to make sure the terms are favorable and the interest rate is lower than what you’re currently paying.
Types of business loans
Term loans are repaid in set intervals over a period of time, usually five to 10 years. They typically have lower interest rates; however, because your debt is stretched out over a longer period of time, you may end up paying more in interest than with a shorter-term loan. Banks, online lenders and other alternative lenders all offer business term loans.
Lines of credit are similar to credit cards in that they allow you to borrow funding up to a certain amount, only pay interest on the amount you’ve borrowed and continue to borrow up to your limit as you pay down your line.
SBA loans are partially guaranteed by the U.S. Small Business Administration and offered through SBA-approved lenders that include banks, credit unions, nonprofit lenders and other alternative lenders.
Working capital loans are usually short-term loans that are used to cover a variety of general business expenses, such as rent and utilities, payroll or inventory.
Microloans are short-term business loans approved in relatively small amounts, typically $50,000 or below. Their approval terms are usually more flexible than higher-dollar-amount loans.
Invoice financing, or accounts receivable financing, involves using unpaid customer invoices as collateral on short-term business loans. An invoice financing company will front you a certain percentage of your invoices, and you repay the loan once you receive payment from your customers.
Commercial real estate loans, or commercial mortgages, are long-term loans (up to 25 years) that are used to purchase real estate for your business.
Startup loans are offered to pre-revenue businesses, or businesses that have been operating for under two years. Startup businesses are considered risky to fund because they don’t have an established track record of financial success. That means finding startup funding can be tricky; getting a startup loan will usually require strong personal credit, strong business financials or projections and possibly collateral.
Business loan vs. personal loan
Pros and cons of business loans
They can help your business grow. Generally, business loans can help businesses own real estate, take on bigger contracts, hire more personnel and grow in other ways. Some lenders, like community development financial institutions (CDFIs), may offer resources to help you run your business, like business advisory services.
May be cost effective. Depending on the type of loan, your business history and personal financial history, loans can be a relatively inexpensive way to start, sustain or grow your business. Banks usually offer the best terms and lowest interest rates, but have the strictest qualification requirements.
They can help build your business credit. Business credit history can help your business get approved for future funding, qualify for more competitive interest rates and even get you access to lucrative business credit card offers. Like personal credit, one way to build business credit history is by showing you can pay off money you’ve borrowed.
They can be expensive. Though certain types of business loans can be very affordable, others can also be expensive, which could cause cash flow issues for your business. Lines of credit and loans from alternative and online lenders generally have the highest interest rates, depending on your business history and personal credit.
They can affect your personal credit. Many business loans will require you to sign a personal guarantee, which means that you are individually responsible for paying the loan if your business can’t. If your business fails and you’re not able to make payments, this can negatively affect your personal credit history.
How to improve your chances of being approved for a business loan
Though each lender and loan type comes with different requirements, there are some general things you can think about to start preparing for business financing.
Check your personal credit score
Most lenders will want to know your personal credit history when evaluating a business loan application. Banks typically want to see a credit score of at least 680, while some online lenders require a minimum of only 500. Some alternative lenders have no minimum credit score requirement. No matter what your credit score is, knowing your credit history and being upfront with a lender can go a long way in the application process.
Collect your business documentation
If your business has been operating for some time, a lender will want to look at any available data, including bank and financial statements. If your business hasn’t started operating yet, your business plan and financial projections will be a crucial part of your application. In any case, having business information available will show a lender that you’re serious about your application.
Assess available collateral
Offering collateral can strengthen your loan application and significantly improve your chances of getting approved for a business loan because it shows the lender that you have skin in the game. It helps them recoup losses if you default on your loan. Large equipment, real estate or inventory are all collateral that could help to secure a business loan.
Save up for a down payment
Some types of business loans, like commercial real estate loans, require down payments (lump sums upfront that reduce the amount of money you have to borrow). Even when they’re not required, down payments on business loans can significantly improve your chances of getting approved and may save you money in the long run by reducing the amount of money on which you’ll pay interest.
Find the right business loan
The best business loan is generally the one with the lowest rates and most ideal terms. But other factors — like time to fund and your business’s qualifications — can help determine which option you should choose. NerdWallet recommends comparing small-business loans to find the right fit for your business.