Small Business Lending: Every Answer You Need to Successfully Find a Loan

When you’re new to the world of small business lending, it’s not uncommon to have more questions than answers. The more you learn, the more questions you have… It can feel like a never-ending rabbit hole.

Today, we’re here to answer the many questions that are likely to come up before your loan application process, while you’re shopping around and applying, and after you sign. We hope these answers help you to make an educated, confident borrowing choice.

Before Shopping For a Loan

How much can I afford to borrow?

Almost without fail, the first question every small business lender or loan broker will ask you is, “How much do you need?” Sounds like a straightforward question, right? But in reality, there’s a lot to consider.

You probably have a “pie in the sky” dollar amount that you’d love to have on hand to grow your business. Imagine what you could do with a cool $5 million!

Then there’s how much you actually need in order to achieve your business goals. And finally you’ll come to how much you can actually afford to borrow—which might match your needs, or be more limiting.

But how exactly do you determine how much your business can afford to borrow? Don’t worry—there’s a formula for that.

Cash Flow / Loan Payment = Debt Service Coverage Ratio

Your debt service coverage ratio (DSCR for short) is a mathematical expression of your periodic cash flow, divided by your loan payment for the equivalent period.

So, for a loan with monthly payments, you would take your current monthly cash flow and divide that by the loan payment to calculate your DSCR.

All lenders will expect a DSCR of at least 1—the minimum indicator that you’ll have the cash on hand to make your loan payments. However, we all know that unexpected expenses come up in business, meaning it’s best to have a little cushion in your cash flow. That’s why most lenders look for a DSCR of at least 1.35.

Beyond the lender’s requirements, you can use the DSCR to determine the amount of cushion you’re comfortable with. A ratio closer to 2 or above is considered conservative, while any ratio under 1.15 considered higher risk.

How will my credit impact my small business lending options?

When you go to apply for a business loan, you may be surprised to learn that your personal credit score is one of the most important factors in determining your loan eligibility!

From the lender’s point of view, they’re lending money to a small business owner, not just the business itself. So as the business owner, the way you handle your personal finances has incredible significance.

Before you dive any further into the small business lending process, check your credit score. Yes, right now! Some credit card companies will show you your credit score right on your monthly statement, or when you sign onto your online account. Otherwise, you can find it on sites like this.

Got it? Good. But wait, what exactly does that three digit number mean again?

If your credit score is 700 or above—congratulations! You’re in perfect shape, and will likely have excellent small business lending options available.

Is your credit score between 650-699? Great! You should still have plenty of options.

If your credit score is 575-649 range, that’s considered average. You probably won’t qualify for the very best interest rates out there, but depending on other financial considerations, you’ll likely still have some options available.

Unfortunately, if your credit score is in the mid-500 range or lower, you have what’s considered a poor credit rating and will have fewer options available.

It’s amazing how three little digits can have so much power.

Can I do anything to improve my credit rating?

Yes and no.

Sadly, there aren’t any magical quick fixes to improve your credit score overnight. But with time and patience, you can implement changes to get your credit rating back to where you want it. Here are a few steps you can take:

Pay On Time, Every Time

With only a few exceptions, the unfortunate reality is that bad credit ratings are the result of bad habits in your spending or debt management. Making late payments, overdrafting your bank account, or letting bills go to collections can all slowly take a toll on your credit and impact your ability to qualify for small business lending.

So the first and most important way to turn your credit rating around is to change your habits. Set up auto-pay systems or internal reminders to be sure you make payments on time. Make a habit of checking your finances regularly to be sure that your money goes where it needs to.

The impact of these changed habits on your credit score won’t be immediate, but eventually they’ll result in a lasting change for your financial future.

Improve Your Debt to Credit Ratio

The ratio between how much credit is available to you and how much you’re actually using is called your debt to credit ratio, and it has a significant impact on your credit score. If your credit cards are constantly maxed out, or if you’ve taken out several small personal loans or lines of credit, all that debt will eat away at your credit score.

You can improve your debt to credit ratio by paying off debts or by increasing your credit limit on any existing credit cards (without increasing your spending).

Dispute Any Inaccuracies On Your Credit Reports

Regularly check your credit report through all three major reporting agencies—TransUnion, Experian, and Equifax—for any discrepancies or irregularities in the reporting. Make sure that you recognize all of the accounts and entries, and if you find an error, contact the reporting agency in writing to correct it.

The process of working with credit agencies to fix errors requires a lot of persistence, but it’s worth the effort to get the credit score you deserve.

What other factors will lenders consider most heavily?

Although significant, your credit score isn’t the only factor determining whether you’ll be approved for a small business loan. Consider how you’ll stack up with these three additional factors, which each may be weighted equally to your credit score in determining your eligibility for small business lending.

Time in Business

Lenders know that the younger your business is, the less likely you are to make it for the long haul. That’s why the amount of time your business has been operational can significantly impact your eligibility for a small business loan.

If you’ve been in business for more than two years, you’ll typically be considered highly fundable. Made it through your first year of business? If so, you’ll likely still have options—depending on how you rate for other factors. But if you’ve been in business for less than a year, you may have a harder time being approved for small business lending.

Annual Revenue

To make regular payments on your small business loan, you’ll need to have cash coming in, right? Lenders understand this, so they like to see that you already have enough cash coming into your business to cover your loan payments, along with the rest of your company’s operating expenses.

Typically, lenders  will want to limit your total loan amount to less than 12% of your business’s total revenue, ensuring that you’ll be able to make your loan payments even when unexpected expenses come up.

Average Bank Balance

From a leaky roof to a bad batch of inventory, it’s inevitable that unexpected expenses come up in business. And if you’re not prepared, these little extra costs can add up to send your business into a cash flow tailspin you can’t recover from.  

That’s why even if your sales numbers are fantastic, lenders still expect you to have some savings in the bank for a rainy day.

For maximum fundability, aim for an average bank balance equal to at least three months of operating expenses for your business, including your loan payment. If that feels out of reach, start with $1,000 and build your savings from there. Any amount of extra cushion will help your loan eligibility.

While You Shop Around

Should I apply for a small business loan from a bank?

There’s no denying that bank loans and lines of credit are the best priced small business lending options out there. The rates of bank loans, regulated by multiple government agencies, are significantly better than unregulated alternative loans.

Only one problem, here—bank loans are almost impossible for small businesses to qualify for! 82% of small business loans are denied by banks. And even for those who are approved, securing your loan can take months.

So if you need cash fast, or if your credit score isn’t the best of the best, you may need to look beyond your local brick-and-mortar bank and consider a wider breadth of borrowing options, such as those available from online alternative lenders.

What online small business lending products should I consider?

In addition to the relative ease of qualifying, another benefit to online alternative lending is the much wider variety of loan products available than what you’d find through a traditional bank. Let’s review the traditional and non-traditional small business lending options available through online lenders:

SBA Loan

While the U.S. Small Business Administration does not directly lend money to business owners, the agency does guarantee a portion of the principal on certain loans through intermediary lenders, in order to incentivize small business lending. Though many banks do serve as intermediary lenders for the SBA, there are alternative lenders who service SBA loans as well.

Term Loan

A traditional term loan is probably what you naturally think of when you think of a business loan. You borrow a fixed amount of money, usually for a specifically stated business purpose, and pay back the loan over a fixed term and typically at a fixed interest rate. If you’re looking for a fixed interest rate, predictable monthly payments. and flexibility in how you use your small business loan, a term loan may be the choice for you.

Business Line of Credit

A business line of credit works similarly to a credit card, and is the most flexible form of funding you can get for your business. Once established, a line of credit gives you a set dollar amount of capital that you can draw against to buy inventory, handle seasonal cash flows, pay off other debts, or address almost any other business need.

Invoice Financing

If delays in accounts receivables are endangering your cash flow, then invoice financing—or accounts receivables financing, as it’s sometimes called—is a helpful way to get the cash you need immediately.

Think of this as selling the amount owed on your unpaid invoices. You sell for about 80% of the outstanding amount, which is advanced to you in cash almost immediately. Then the invoice financing company will set about trying to collect on those unpaid invoices, and you’ll receive a portion of that 20% balance back proportional to the amount the company is able to collect.

Equipment Financing

If you mainly need funding to purchase equipment such as computers, machinery, or vehicles, an equipment loan may be a great fit for your needs. This loan works similarly to a car loan in that the equipment itself acts as collateral for the loan—meaning you likely won’t be asked to put up your own collateral as you could with other loans.

Merchant Cash Advance

If you operate a seasonal business, it can be difficult to make regular daily, weekly, or monthly payments during slower sales months. One great solution to this challenge may be a merchant cash advance, which is a lump sum payment of liquid capital offered to a business in exchange for a percentage of the company’s future sales.

When a borrower receives cash from a merchant capital provider, he agrees to pay back the cash advance, plus a fee, by allowing the provider to automatically deduct an agreed upon percentage of his company’s daily credit and debit card sales.

What fees do I need to watch out for?

Your first glance at a loan’s interest rate can paint a very inaccurate picture of your actual cost of lending. Not only are not all interest rates created equal, but a lender’s various fees can quickly add up to make your loan cost much more than you originally intended. Watch out for these common small business lending fees:

Application Fee

For lenders, the costs of running credit checks and paying underwriters to process loan applications can add up, cutting into their profits on interest from your loan. To mitigate those costs, some lenders will charge you an application/ or processing fee upfront.

Origination Fee

Typically quoted as a percentage of the principal, the origination fee reflects the costs your lender incurs each time they make a loan.

Guarantee Fee

This fee applies specifically to SBA loans, which are partially “guaranteed” by the government in order to assist lenders with approving loans for small businesses. To participate in the SBA’s programs, your lender will have to pay a portion of the guaranteed amount back to the government—a cost they may pass along to you in the form of a guarantee fee.

Check Processing Fee

Most lenders will ask you to make loan payments through Automated Clearing House (ACH), an electronic network for financial transactions in the United States. If you prefer to pay by check, you might incur an extra check processing fee.

Late Payment Fee

Add this to your list of reasons to make your loan payments on time, every time. Some lenders will charge a fee whenever you’re late on a payment.

Pre-Payment Fee

Maybe your cash flow is looking great and you can afford to pay off your small business loan a little early. Great news, right? But not so fast! Occasionally, loan agreements will include a prepayment penalty, which is a hefty fee charged if you decide to pay off your loan early. In some cases the cost of this fee can even outweigh the interest saved, so do the math before you sign that final check.

Applying For Your Loan

What documents do I need to prepare?

To process your loan application, lenders require quite a bit of documentation about your business’s financial standing. You’ll save time when you go to apply if you prepare these documents beforehand.

Business Plan

Your business plan is the lender’s introduction to who you are and what your business is about. It tells them your mission and goals, and shows them the roadmap you’ve set out to succeed. While not always required, a solid business plan may help lenders believe in your company’s chances for success (meaning they’ll believe in your ability to pay back your full loan, plus interest, on time).

Balance Sheet

Your balance sheet represents a snapshot of your business’s financial standing at a point in time. Most lenders will ask for a balance sheet updated within the last 60 days. If you use accounting software like Quickbooks, you should be able to pull your balance sheets easily—or use our free balance sheet template to create your own.

Profit & Loss Statement

Also known as an income statement, these documents show the cash flow of your business alongside its ability to meet outstanding debt requirements. Most lenders recommend including both a year-to-date P&L, updated within the last 60 days, and total profit and loss statements for the last two years.

Business Bank Statements

Provide at least 4 months’ worth of banking statements, 6 if you have them, and 12 if your business is seasonal. Remember to include all pages of the bank statements for each month available.

Sales Forecast

Especially for newer businesses, balance sheets and profit and loss statements doesn’t always tell the full story of a business’s potential. Though not required, a well-researched sales forecast may help convince your lender to take a chance on your young business.

Business Debt Schedule

This document shows the lender all of your outstanding debts, amounts, and payments. If you don’t already have one, use our business debt schedule template to create a payment schedule for your business.

Personal Tax Return

Your lender will likely ask to see your most recent personal tax return to verify your income. If you haven’t filed your taxes for this year, you’ll want to either do so before you apply or provide your most recently filed year along with your extension paperwork for this year.

Business Tax Return

If you’ve been in business for awhile, have your last 2 to 3 years’ business tax returns on hand to show your long-term revenue history. Haven’t filed your business taxes yet for this year? You might want to handle that before you apply.

How do I determine exactly how much my loan will cost?

Even without the impact of various fees on your small business lending costs, you’ve probably realized by now that not all interest rates are created equal. Different formulas and compounding schedules mean that a factor rate, monthly, or annual interest rate can all sound the same while actually reflecting very different costs.

Ask Lenders for the APR

To make sure you’re comparing apples to apples, you’ll want to ask the various lenders to disclose the loan’s Annual Percentage Rate, or APR. This number is a standardized reflection of your true cost of borrowing, including both the interest rate and any standard fees incurred.

Calculate Your Own APR

If you’re unable to find out your loan’s APR from your lender—first, make note of that red flag. It could be an indication that the true cost of the loan is less than favorable.

Then, use one of Fundera’s free APR calculators to determine what your true cost of borrowing will be. There are different calculators appropriate for virtually every time of small business loan.

Should I offer collateral or sign a personal guarantee?

No one goes into a small business lending agreement with the intention of not being able to pay back the loan—but the reality is that things happen. Not all businesses succeed.

To mitigate that risk, as part of your loan application, some lenders may ask you to offer collateral or a personal guarantee on the loan amount. In some cases doing so can help you qualify for a more affordable loan, because it gives the lender some recourse in the event that you were to default on your loan.

Usually you’ll first be asked to offer some property of substantial value—such as your home–as collateral on your loan. This means that if you default, the lender can seek a judgment against you and claim the title to your home or property as repayment for the loan.

If you don’t have property to offer as collateral, you may be asked to sign a personal guarantee instead. Depending on the type of guarantee, this can mean that the lender can go after any of your assets now and in the future as repayment if you default on your loan—think your savings, retirement accounts, your kids’ college funds…

Signing a personal guarantee is certainly a big risk—which is why lenders consider it such a vote of confidence in your business. Knowing what you have to lose if you default on your loan makes it that much more likely that you’ll make your payments on time, every time.

Ultimately, this decision is a personal one. How confident are you in your business model? How certain are you that you can afford payments? You’ll have to evaluate your own financial standing and personal responsibilities to determine whether the risk of signing a personal guarantee is worth the return.

How long will it take to process my loan application?

This answer can vary widely depending on the type of loan product you’re applying for. SBA Loans take a notoriously long time to process—think several weeks or even months—since they have to be approved by both the SBA and an intermediary lender.

Other term loans may also take a few weeks to process, depending on the lender. On the other hand, many online alternative loan products—like an equipment loan, invoice financing, or merchant cash advance—can be processed in as little as 24 hours, with cash in hand within two days.

Of course, these turnaround times are contingent on filing a complete and accurate application. Discrepancies or missing information can cause major delays, so make sure you have your ducks in a row before you submit.

After You Sign

Congratulations! We hope this information will lead you to make an educated, confident choice about your small business lending options. Do your homework and submit a stellar application, and you’ll be happy with your final borrowing choice.

Remember to track your payments using a loan amortization schedule to be sure you’re paying on time, every time—and keep in mind that if you didn’t quite qualify for the rate you’d hoped, you may have the option to refinance your loan later on, when your credit situation is a bit better.

The most important thing is that you’ve educated yourself about all of your small business lending options, and you can get back to the important work of making your business dreams come true.

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from Fundera Ledger https://www.fundera.com/blog/2015/11/04/small-business-lending/