What Is a Small Business Loan? Exploring the Fundamentals

What is a small business loan? This is an essential question that every new (or seasoned) small business owner should be asking.

Whether you have an invention or a skill you want to share with the world or you simply like the idea of working for yourself, there are plenty of reasons to pursue small business ownership.

Yet more often than not, entrepreneurs in the early days of their business journeys tend to be halted in their tracks by one overwhelming revelation: In order to make money from your business, it will probably take some money—and often quite a bit up front—to get your venture off the ground.

 

This is especially true of large ventures that require a big physical space, inventory, equipment, or other forms of high overhead. But even a small service-based or home business will still face upfront costs before the income starts rolling in.

This vicious cycle of needing money in order to make money is as old as business itself. And so is the most common solution to every entrepreneur’s dilemma: the small business loan.

But what is a small business loan, and how does this financing solution work to meet the needs of business owners?

To help you decide whether a small business loan is the right choice for you and to find the right loan product for your business, follow along with us to better understand how small business loans work, the different types of loan products available, and the qualification standards you’ll need to meet. Then it’s up to you to be approved for the small business loan that will take your venture to the next level.

What Is a Small Business Loan?

Though the terms, costs, uses, and other particulars can vary widely, there are some basic guiding principles that define what small businesses loan loans are and how they work.

A small business loan is initiated when a borrower—typically one business owner or group of co-owners—borrows a sum of money from a lender based on a set, pre-specified agreement to repay that sum plus interest over a period of time. That’s it.

So, if you have a business, and you borrow money from someone on behalf of that business with a promise to pay it back—you’ve engaged in a small business loan.

Of course, within that wide-ranging definition, a variety of different types and styles of loan agreements have evolved over time between small business lenders and the owners who borrow funds for their businesses.

Read on to learn more about the fundamentals of how small business loan agreements are put together, the various loan products available, and how lenders decide who qualifies for individual business loans.

Small Business Loan Terms to Know

Before we dig further into the specifics of “what is a small business loan,” and how to find the right small business loan for your growing venture, let’s take a moment to walk through some important terms that you’ll likely come across as you compare various loan products.

Having a clear understanding of these terms is critical to making sure that you find an affordable and appropriate small business loan for your needs.

• Borrower: An individual or business that borrows money from another with a promise to repay the full amount plus interest based upon agreed terms.
  

• Lender: An individual or institution that temporarily offers funds to a borrower with the expectation of repayment according to set terms.
  

• Principal: The lump sum of funds provided by the lender to the borrower.
  

• Interest: The amount paid by the borrower to the lender in exchange for the privilege of borrowing money. The amount of interest due is calculated based on the amount of funds borrowed and the amount of time that passes until repayment.
  

• Payments: Periodic repayments made by the borrower to the lender to return both the principal amount borrowed and the interest due to the lender.
  

• Term/period: The total length of time that passes between when funds are provided by the lender to the borrower and when the loan principal and interest has been fully repaid by the borrower to the lender.
  

• Collateral: Valuable asset or piece of property offered by the borrower as a means of securing or guaranteeing payment on a loan. In the event that a loan is not paid in full, the lender can seize the promised collateral as a means of payment.
  

• APR: The annual interest rate, expressed as a percentage, that is charged by the lender to the borrower. This standardized rate is the most common expression of interest charged for traditional term loans.
  

• Factor fee: An alternative means of expressing the interest charged on a loan based on a flat percentage of the amount borrowed. Also called a factor rate, this expression of interest is most often used with short-term small business loans.

Qualifying for a Small Business Loan

Now that we’ve covered the basics of “what is a small business loan?” Let’s dig into how to secure one.

Exact application requirements and qualification standards for a small business loan tend to vary based on the lender, the loan type, and the planned use of funds. That said, there are three basic qualification standards that almost all lenders will evaluate as part of the small business loan approval process.

Learn more about these standards below so that you’ll be more familiar with how lenders will assess your small business loan application:

Personal Credit Score

You may be surprised to discover that when it comes to deciding whether or not to lend money to your business, most lenders will actually look to your personal credit score as a primary evaluation tool.

Particularly if your business is very young—or if you’re seeking a small business loan for the first time—lenders know that your business itself doesn’t have much of a track record when it comes to managing debt. Looking to how you’ve managed finances in your personal life is the lender’s best available option for determining how well you’ll manage your finances and repay debts within your business.

Wondering how your personal credit score stacks up? Here’s a general breakdown of how scores are assessed by small business lenders:

• Excellent: 781-850
• Good: 661-780
• Fair: 601-660
• Poor: 501-600
• Challenged: Below 500

Time in Business

Unfortunately, one of the three major factors that will most impact your ability to qualify for a small business loan is one that’s totally out of your control: the amount of time you’ve been in business.

Lenders know that statistically, about 20% of businesses fail within the first year of operations—so the longer you’ve been in business, the more stable your venture is statistically likely to be.

Among most lenders, the one-year mark—and in particular the two-years-in-business mark—is considered the major business milestone that might dramatically impact your access to funds. But until your business reaches that milestone, when a lender has strict qualification standards for time in business, there’s little to do but wait.

Annual Revenue

Unlike with the two loan approval standards above, this basic loan requirement probably won’t come as a surprise. To make sure that you’ll be able to repay your small business loan in full, lenders will look to your annual revenue—or the total amount of income that your business is bringing in per year.

As a general rule, an annual revenue of $250,000 is considered a strong benchmark allowing for a wide range of business loan options, while annual revenues of $500,000 will provide for even more possibilities.

This number is particularly important for business borrowers seeking longer term loans, or those who need a large amount of capital. That said, though options will be more limited, businesses with a modest annual revenue of as little as $50,000 might still qualify for SBA microloans as well as certain other small-value business loans.

Types of Small Business Loans

Hopefully, by now, you’re no longer wondering, “What is a small business loan?” and we can dig into the different types of business loans that exist.

Though the basic formula of small business lending remains a constant, lots of different loan types and terms have evolved over the years to suit the needs of different lenders and different borrowers. And that’s a great thing, because not all businesses have the same financing needs.

Factors like how you plan to use your loan and how quickly you’ll be able to pay it back can have a dramatic impact on what types of loans you will qualify for and what the cost of those small business loans will be.

Now that you understand the basics of what a small business loan is and how it works, let’s walk through some of the most commonly sought after small business loan options to help you identify the best choice for your business:

What Is a Term Loan?

When most people ask “what is a small business loan?” the answer they will get will most likely resemble the definition of a term loan.

In this very standardized business loan arrangement, the borrower is offered a lump sum of funds for a set term of between one and five years, interest is accrued at a fixed rate over the life of the loan, and the borrower makes fixed monthly repayments on principal and interest until the loan is paid in full.

Here’s a quick breakdown of the numbers behind standard term loans:

• Loan amount: $25,000-$500,000
• Loan term: 1-5 years
• Interest rate: 7%-30%
• Minimum time in business: 1 year
• Minimum annual revenue: $90,000
• Minimum personal credit score: 600

Term loans are popular because they are straightforward, they offer a large sum of funds to be borrowed over a longer period, and the interest rates tend to be the lowest available. That said, term loans tend to carry higher qualification standards than for other small business loan products—so brand-new business owners or those with poor credit may have to consider an alternative option.

What Is a Short-Term Loan?

Just as you might have guessed, short-term loans are very similar to traditional term loans with the distinction that funds are borrowed for a shorter period of time—most often between 3 and 18 months.

As with a term loan, these loan products offer a fixed sum of capital up front with consistent payments due over time according to a set schedule. However, while term loans typically follow a monthly payment schedule similar to a mortgage or car loan, short-term loans tend to require weekly or even daily payments.

Let’s break down the basics of this small business loan option:

• Loan amount: $2,500 to $250,000
• Loan term: 3 to 18 months
• Interest rate: Starting at 10%
• Minimum time in business: 1 year (two years preferred)
• Minimum annual revenue: $50,000
• Minimum personal credit Score: 525

Short-term loans can be a great tool for businesses who need quick access to cash to cover basic expenses or take advantage of worthwhile business opportunities—or for those with poor credit.

Keep in mind, however, that interest rates for short-term loans tend to be higher than with other loan products, and most operate on a weekly or even daily repayment schedule. As a result, it’s important to carefully consider your ability to repay your short-term loan on schedule before pursuing this small business loan option.

What Is Equipment Financing?

As the name suggests, equipment financing is a small business loan specifically designed to finance the purchase of equipment needed for the operation of a business.

The specific terms of equipment financing work very similarly to a car loan in that the equipment itself serves as collateral for the loan, so no outside collateral is needed. Because of this, equipment financing loans tend to have more accessible qualification standards for borrowers than other forms of small business financing.

• Loan amount: Up to 100% of equipment value
• Loan term: Equivalent to the expected life of the equipment
• Interest rate: 8%-30%
• Minimum time in business: 11+ months
• Minimum annual revenue: $100,000
• Minimum personal credit score: 600

Of course, equipment financing is only a good fit for businesses that have significant equipment needs, since funds from these loans cannot be put toward other uses and financing is only available up to the full cost of the equipment. That said, equipment loans can be used toward the value of computers, machinery, vehicles, printers, commercial kitchen appliances, and more—so this lending solution can apply to a wide variety of industries.

What Is a Business Line of Credit?

If you’ve ever taken out a personal credit card, you’re already familiar with the basic premise behind a business line of credit. Unlike most others small business loan products, which offer borrowers a lump sum of capital upfront, a business line of credit is approved as a maximum credit amount from which funds can be drawn as needed.

The best part? Just like with a credit card, you only pay interest on the funds you draw from the total credit line—meaning you’ll never find yourself paying interest on funds that you’re not actively using.

If you’re considering a line of credit for your business, here are the specifics you need to know:

• Loan amount: $10,000 to $1 million
• Loan term: 6 months to 5 years
• Interest rate: 7%-25%
  
• Minimum time in business: 6 months
• Minimum annual revenue: $50,000

Even if you’re not certain about your need for a business line of credit, applying for this small business loan product is a great way to build up your business and personal credit history while getting easier access to funds in the event of a business cash flow emergency.

What Is Invoice Financing?

Sometimes known as accounts receivable financing, invoice financing is a type of small business loan that lets business owners obtain cash on demand based on outstanding invoices or money owed to the business.

Here’s how it works: Invoice financing companies will typically offer an immediate cash advance equivalent to about 85% of the total value of your outstanding invoices. From there, the remaining 15% of your accounts receivable will be paid to you at a later date, less the company’s factor fee.

The exact cost of your invoice financing loan will depend upon how quickly your customers pay their invoices, with fees assessed as a percentage per week that the invoices remain outstanding.

Any company with outstanding accounts receivable can qualify for invoice financing, but most invoice financing companies prefer to work with businesses that have been operational for at least six months and have at least $50,000 in annual revenue.

Before You Choose a Small Business Loan

At this point, we hope that you formed a basic understanding of what a small business loan is and how this form of business financing works. You might even have some idea about what type of loan would be a good fit for your business based on your needs and qualification standards.

Yet as you continue to shop around for a small business loan, further research will be needed into the specifics of loan products you’re considering to make sure that you fully understand its implications before you apply. Consider working with a small business loan broker, financial advisor, or loan marketplace to help you navigate the application process and find the best available loan for your business.

Choosing to take out a loan to grow your small business venture is a serious decision, but it’s also a very exciting one.

Now that you can answer the question, “What is a small business loan?” we hope you’ll feel better prepared to pursue the next phase of your entrepreneurial journey.

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