Among the many challenges of running a small business is getting a small-business loan. Some entrepreneurs need outside financing to start or grow their businesses and cover day-to-day expenses including payroll and inventory.
Although finding, applying for and getting approved for small-business loans can certainly be difficult, the more prepared you are, the better. Here’s how to get a business loan in five steps.
Table of contents:
Know why you need the money
Find the right loan
— Types of loans available
Find the best lender for you
See if you have what it takes to qualify
Get your documents ready and apply
1. Ask yourself, why do I need this loan?
Lenders will ask you this question, and your answer will likely fall into one of these four categories:
- To start your business
- To manage day-to-day expenses
- To grow your business
- To have a safety cushion
2. Decide which loan is right for you
Your reasons for needing the loan will dictate the type of small-business loan you get.
If you’re starting a business, it’s virtually impossible to get a loan in your company’s first year. Instead, you’ll have to rely on business credit cards, borrowing from friends and family, crowdfunding, personal loans or a microloan from a nonprofit lender.
To manage day-to-day expenses, or working capital (to cover, say, payroll, inventory, rent or other monthly bills) you’ll want:
- a short-term cash flow loan, a quick, one-time injection of cash that is repaid over a short period of time;
- a line of credit, which allows you to borrow and repay only the money you need (similar to a credit card);
- or accounts receivable financing. Also known as invoice factoring, this allows you to get your unpaid invoices advanced and then repay the advance amount (plus a fee) after your customers pay you.
If you want to grow your business by expanding to a new location, adding a new product or service or buying a new piece of large equipment, you’ll want:
- a term loan, a lump sum of cash that requires fixed payments. Your loan shouldn’t outlast the product or equipment you’re buying. For example, if you’re purchasing a new pizza oven that you expect to use for five years, get a loan with a term of about five years.
If you don’t need cash immediately but want a safety cushion, in case of an emergency, you’ll want to get a line of credit or a term loan with the lowest rate possible.
Nerd note: Ideally, you should get a bank line of credit long before you actually need it, says Suzanne Darden, a business consultant at the Alabama Small Business Development Center. That way, you won’t need to scramble for cash when an emergency strikes.
3. Determine the best type of small-business lender
You can get small-business loans from several places, including banks, nonprofit microlenders and online lenders. These lenders offer products including term loans, lines of credit and accounts receivable financing. Below we’ve listed your three main routes to financing.
Nerd note: You should approach small-business loan shopping just as you would shopping for a car, Darden says. Once you determine which type of lender and financing vehicle is right for you, compare two or three similar options based on annual percentage rate (total borrowing cost) and terms. Of the loans you qualify for, choose the one with the lowest APR.
If you have collateral, good credit and don’t need cash fast? Banks.
Traditional bank options include term loans, lines of credit and commercial mortgages to buy properties or refinance. Through banks, the U.S. Small Business Administration provides general small-business loans with its 7(a) loan program, short-term microloans and disaster loans. SBA loans range from about $5,000 to $5 million, with an average loan size of $371,000.
Small businesses have a tougher time getting approved due to factors including lower sales volume and cash reserves; add to that bad personal credit or no collateral (such as real estate to secure a loan), and many small-business owners come up empty-handed. Getting funded takes longer than other options — typically two to six months — but banks are usually your lowest-APR option.
Nerd note: State and local governments might also offer financial assistance, so check out the SBA’s Loans and Grants Search Tool to get a list of financing programs.
If you can’t get a traditional loan because your company is too small? Microlenders.
Microlenders are nonprofits that typically lend short-term loans of less than $35,000. The APR on these loans is typically higher than that of bank loans. The application may require a detailed business plan and financial statements, as well as a description of what the loan will be used for, making it a lengthy process. Also, the size of the loans is, by definition, “micro.” But these loans may work well for smaller companies or startups that can’t qualify for traditional bank loans, due to a limited operating history, poor personal credit or a lack of collateral.
Popular microlenders include Accion Kiva, the Opportunity Fund and the Business Center for New Americans.
If you lack collateral and operating history or need cash fast? Online lenders.
Alternative lenders provide small-business loans and lines of credit from $500 to $500,000. The average APR on these loans ranges from 7% to 113%, depending on the lender, the type and size of the loan, the length of the repayment term, the borrower’s credit history and whether collateral is required. These lenders rarely can compete with traditional banks in terms of APR.
But approval rates are higher and funding is faster than with traditional banks — as fast as 24 hours. Examples of popular online lenders include OnDeck, Kabbage, SmartBiz, Dealstruck, Lending Club, Prosper and Funding Circle.
4. Find out if you qualify
What’s your credit score?
Your place on the credit spectrum is one factor that will determine which loans you’ll qualify for. You can get your credit report for free from each of the three major credit bureaus — Equifax, Experian and TransUnion — once a year. You can get your FICO score for a small fee, or some credit card issuers provide them to their customers.
Banks, which as previously noted offer the least expensive small-business loans, want borrowers with credit scores at least above 680, Darden says. If your credit score falls below that threshold, consider online small-business loans for borrowers with bad credit or loans from a nonprofit microlender.
How long have you been in business?
In addition to your credit score, lenders will consider how long your business has been operating. You need to have been in business at least one year to qualify for most online small-business loans and at least two years to qualify for most bank loans.
Do you make enough money?
Many online lenders require a minimum annual revenue. Know yours and find out the minimum a given lender requires before you apply.
Can you make the payments?
Look carefully at your business’s financials — especially cash flow — and evaluate how much you can reasonably afford to apply toward loan repayments each month. Some online lenders require daily or twice-monthly repayments, so factor that into the equation if that’s the case.
To comfortably repay your loan each month, your total income should be at least 1.25 times your total expenses, including your new repayment amount, Darden says. For example, if your business’s income is $10,000 a month and you have $7,000 worth of expenses including rent, payroll, inventory, etc., the most you can comfortably afford is $1,000 a month in loan repayments.
(More tips: How to qualify for a small-business loan.)
5. Now, gather your documents
Once you’ve compared your options, it’s time to apply for the loans that fit your financing needs and that you qualify for.
Nerd note: You can apply for multiple small-business loans within a short time frame (about two weeks) without a negative effect on your credit score.
Depending on the lender, you’ll need to submit a combination of the following documents with your application:
- Business and personal tax returns
- Business and personal bank statements
- Business financial statements
- Business legal documents (e.g., articles of incorporation, commercial lease, franchise agreement)
The bottom line
Not every small-business loan is right for every business. To get the loan that’s best for yours, compare your options and match your business’s needs with a loan based on how you intend to use the money, what you qualify for and how much you can afford to pay.
If you need more help, consider talking to a business consultant, Darden says. A consultant can speak objectively and help you find a loan best suited for your business. You can meet with a business consultant for free at your local Small Business Development Center.
Find and compare small-business loans
NerdWallet has come up with a list of the best small-business loans to meet your needs and goals. We gauged lender trustworthiness, market scope and user experience, among other factors, and arranged lenders by categories that include your revenue and how long you’ve been in business.
Teddy Nykiel is a staff writer at NerdWallet, a personal finance website. Email: teddy@nerdwallet.com. Twitter: @teddynykiel.
Steve Nicastro is a staff writer at NerdWallet, a personal finance website. Email: Steven.N@nerdwallet.com. Twitter: @StevenNicastro.
This post has been updated. It was originally published on Oct. 9, 2014.
Image via Shutterstock.
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