Over 80% of successful small businesses need to borrow capital in order to finance their growth. If you’re the owner of a small business, chances are pretty good that you’re a part of that majority. Businesses need cash to thrive and expand, especially in their beginning, and term loans can help—whether to renovate or open a new office space, purchase equipment, hire new employees, implement marketing campaigns, or even refinance debt.
Why not just apply for a line of credit? Well, lines of credit work great for smaller, more frequent purchases, cash flow gaps, or unpredicted emergencies, but a term loan won’t tie up your credit if you invest it in bulk. If you have one or a few big ways to use capital in mind, then a term loan is probably the right form of debt for your business.
All right, we’ve convinced you: a term loan is the smartest option when you need to invest in expansion, renovation, or marketing. But it seems that there’s an endless number of types of loans out there, all of which use different jargon and terminology. In this guide, we’re going to talk about unsecured business loans, which are particularly useful if your business is younger than a few years.
“Securing” a Loan
Most small business lenders, especially banks, will require you to put down collateral in order to take out a loan. In other words, you’ll need to secure the loan by offering the lender the right to sell some asset in the event that you default on the loan. Putting down collateral, which is essentially anything that can be turned into cold hard cash, lets you reduce some of the lender’s risk. They’ll hold the title or deed to your asset until the loan gets paid off in full.Unsurprisingly, most banks would rather offer these lower-risk “secured” loans to businesses in need of cash, especially fledgling businesses without much of a track record.
So what can you do if you aren’t able to post collateral? Many small business owners find themselves in this situation when just starting out. Often, they’re younger clients who don’t own a house or have enough equity in any other type of valuable asset for it to serve as collateral. These clients will need to find themselves business loans that let them lean on their credit scores instead of their assets. (And if your credit score isn’t rock-solid either, there are still options for you—they’ll just be a little pricier.)
These loans might be hard to find, but we promise that they’re out there—and they can be valuable resources, as long as you understand them fully. And that’s what we’re here for! Let’s work through all the steps of understanding, applying for, and receiving loans without collateral together.
No Collateral: Your Best Options
Broadly speaking, there are two types of financing that work well if your only collateral is your business itself: online term loans and merchant cash advances.
Merchant cash advances (MCAs) are a quick way to borrow cash with very little paperwork. The merchant offering the cash advance will take a portion of your future credit card sales every day until the advance and an additional fee have been repaid. One advantage here, other than the speed and ease of application, is that MCA providers don’t have any requirements dictating how your business needs to use that cash.
The major disadvantage of an MCA? It’s extremely expensive for the borrower. MCA providers will price their fees as a factor rate of 1.14 to 1.48 of the advance amount—which might not sound terrible, until you work out the math of its pricing as an annualized rate.
Instead of paying interest on the amount of the loan you still have left, you’ll be paying interest on the amount of the original loan. If you borrow $25,000 at a rate of 1.3, for example, you’ll be paying that extra 30% of $25,000 the whole time, even when you’ve already paid back $20,000 of the loan and your remaining principal is $5,000. This means MCAs can end up costing you a rate of up to 80% APR, which can be catastrophic for new businesses struggling to get on their feet.
That leaves us with online term loans. Online term loans are basic traditional loans, in which a lender will provide you with cash upfront that you’ll repay at a fixed rate over a specified length of time. Generally speaking, the longer the term, the “better” the loan is… But the harder it is to get. And while most online lenders might not require specific collateral—like a car, house, or piece of equipment—they’ll likely put a blanket lien on your business to insure their payment.
Short-term loans usually need to be repaid over a period of 3 to 18 months, as opposed to the one- to five-year period of a medium-term loan. The main factors to consider when comparing these loans are interest rates, repayment schedules, fees, and eligibility factors.
1. Interest rates
First off, know that interest rates for online loans are higher than those for secured bank loans. This makes sense if you think about it: a lender is taking on a lot more risk by lending to you without collateral, so they’ll want more repayment. For you, this means that your payments will be higher each month—or day, or week, depending on your payment schedule—than they would be for a secured loan. Think of it as the price you pay—literally—for not needing to put any specific assets on the line.
Interest rates also differ depending on the length of term. Short-term loans will come with much higher interest rates than long-term ones, sometimes ranging from 25% to 60% APR. Lenders often are able to make their money back a few months into the loan, thanks to these hefty rates. Long-term loan interest rates range from 6% to 19% APR, which is a much better deal for the borrower. Note that even for short-term loans, the interest rate is still much better than it is for MCAs—and why they might even still seem high, remember that the alternative is no funding at all.
2. Repayment schedules
Short-term loans have shorter-term repayment schedules. Not only do you have fewer months in which to pay the loan back, but you’ll also need to make payments daily or weekly, whereas with medium-term loans, you’ll usually make monthly payments.
This is important when considering both interest rates and your cash flow. Daily payments, because they’re for short-term loans with higher interest, are higher-cost payments. This means that you’ll be paying significant amounts of money every day to your lender during the length of the loan. This could be problematic for many businesses, given that a business’s income isn’t necessarily steady day-to-day. If you’re a contractor, for example, you might receive only one deposit per month, which makes daily payments a major budgetary problem. The last thing you want to do is to take on a loan to cover your loan. And even if you don’t have cash flow issues, you don’t necessarily want to worry about remembering to make payments every day—although many short-term lenders will deduct your payments automatically from your bank account.
The monthly payments of the medium-term loans, on the other hand, give your business a little more flexibility with its cash flow.
We know—you’re already paying extra money in interest, so the last thing you want to do is pay even more money in lending fees!
When you’re comparing offers, be on the lookout for prepayment penalties, which are fees that you’ll be responsible for if you pay off your loan early. Different lenders enforce different kinds of penalties, from flat rates to percentages of remaining interest, so sometimes it might actually make more sense not to pay your loan off early!
(Why do lenders charge you money for being responsible? Because they had been expecting extra money from you in interest—and when you pay off the loan early, you rob them of that money.)
4. Eligibility factors
Given the lower rates and more flexible repayment schedules of the longer-term loans, they’re more desirable. So how does a lender decide whether or not your business qualifies?
The biggest factor that lenders take into consideration is your credit score. In this case, consider that there’s very little difference between personal credit and business credit when it comes to what they look at: all information is fair game. Lenders will always consider personal credit scores, how many open credit lines the borrower and the business have, and whether or not any accounts are in collection. (A collection account is a debt that continues to haunt you: if you’ve failed to pay off a debt in the past, the creditor might’ve sold it to a collection agency, which will harass you until it’s paid—and even then, it’ll still remain on your credit report. Bad news for your credit score.) Every lender will weigh these factors slightly differently depending on their underwriting process, too.
Short-term business loans are relatively easy to obtain, requiring a credit score of only 540+. Longer-term loans, over a period of years, generally require credit scores of at least 620.
Other factors that lenders take into account are the length of time a business has been operating and its annual revenue. Any business that’s less than a year old has little chance of obtaining a medium-term loan, for example. Most of these lenders require at least 2 years of operating history, with an annual revenue of at least $75,000. Short-term lenders are more flexible on this point and will work with businesses that have only been around for a few months and who aren’t yet quite as profitable.
The last factor determining your loan eligibility is the purpose of the loan. Unlike with MCAs, term loans require you to apply with a specific goal, whether that’s to increase inventory or to expand your business to a new location. The length of the term offered to you will be based in part on these goals. The inventory goal is a relatively short-term one, so the term of the loan will be shorter, whereas expansion is a longer process that will require a longer loan.
Collecting Your Advance
Once you’ve been approved for a loan, it will take a shockingly short amount of time for those funds to reach your bank account. For some short-term loans,, the money will be available to you in as little as 24 hours. Even the longer-term loans generally take less than a week. And these lenders pride themselves on their easy, fast, streamlined application processes, so as long as you’ve got your paperwork in order, you shouldn’t expect the application to take too long, either.
Keep these tips in mind when preparing to apply for a loan.
- You’ll need to provide lenders with records of your personal and business finances, so make sure that you’re keeping excellent ones—balance sheets, income statements, cash flow records, and more. This information should be up-to-date, accurate, and neat. Know your credit score, and be sure to fix mistakes by submitting a written claim, if there are any.
- Keep a goal in mind for your loan, both for its purpose and the amount needed, and be sure to be able to articulate it clearly. Remember, you’re telling a (true!) story about your business’s value and potential.
- Shop around! Make sure that you understand the rates, fees, and payment schedules before you accept any offers, and don’t settle for your first chance at a loan unless you need that cash right away. (And even then, taking the extra time could save you money.)
The online loan marketplace can be tricky to navigate, but we hope this guide has been helpful for you in choosing the right loan for your business. The good news is that if you take out a business loan and repay it in time, it will have a dramatic positive effect on your business’s credit score, making it easier to secure bigger loans at lower interest rates in the future.
from Fundera Ledger https://www.fundera.com/blog/2016/03/28/financing-without-collateral/