How Do Business Loans Work?

In this beginner’s guide, we show you how business loans work from top to bottom…

Updated: April 2, 2024
Matt Crabtree

Written By

Matt Crabtree

|
Rebecca Goodman

Edited By

Rebecca Goodman

 
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Business loans can be useful to companies of any size, to help with a cashflow problem or to invest in more equipment or staff, for example.

Loans for small businesses work in the same way as personal loans to individuals, a loan provider agrees to an amount and an interest rate, and the borrower pays back the money over a set period of time.

There are several different types of loans for businesses, including term loans, and small business administration loans.

The sort of business loan needed will depend on the type of business and its financial health. Other factors such as how long the company has been operating for and how many staff it employs will also be looked at as any lender will want to know you can pay back the money.

This guide explains in depth how a small company loan works, why you might need one, the pros and cons of these loans, and how to find a suitable loan.

How do business loans work?

Let’s start out with a definition. Commercial funding in the form of small business loans is available from several sources, including traditional banks, online providers, and credit unions, among others.

Funds may be used for whatever a company needs, from day-to-day operations to investing in things like machinery and office space.

A business loan may be a lump sum payment or something like a credit card, allowing a company to access funds whenever needed.

To be eligible for a business loan, a provider will look at a company's financial history, to check if it is able to pay back the money, plus interest. Payments usually are made once a month towards the loan, but this depends on the type of loan taken out.

Furthermore, commercial loans might be secured or unsecured. All secured loans must be backed by some kind of collateral, such as property, cash, or assets, which the lender may take back if you default on your payments.

While unsecured loans, which are more common, don't need anything as security. Instead, you will be asked to sign a guarantee, in which you agree to be held liable in the event that the company defaults on its debt repayments.

What do you need a business loan for?

There are lots of reasons why a company might take out a business loan. Companies of all shapes and sizes may require a little extra money but it's typically small businesses that use them. With around 5.5million small businesses in the UK, this makes these loans a popular and useful financial product.

There are lots of different types of loans available, and here we talk in a little more detail about company loans and how they work.

How to take out a business loan

The process of securing a business banking loan for a company, regardless of the kind, depends on the loan and the provider, but most follow the following process:

  • Submit a loan application
  • If you meet the lending requirements, you will be accepted for the loan
  • A bank or other lending organisation gives you the money, charged at a rate of interest
  • All money you borrow must be paid back according to the agreed terms
  • You risk having your assets seized by the lender, or a penalty fee and a mark on your credit score, if you fail to repay the loan on time

How do business loans work?

You probably already know how a company loan works, lenders provider cash to a company for it to use within the business.

Interest will be added to the loan amount and you'll be told the rate of interest before you accept the loan. You will be required to repay the loan monthly, usually, but you may be able to overpay to clear the debt faster, if you're able to.

To explain the process of getting a company loan, it is necessary to address the specifics of each kind of business loan.

Here we look at the most common sorts of business loans, beginning with the easiest to grasp and working our way up to the most complex.

1. Term loan

As this is the kind of loan most people first think of when they hear “business loan”, we'll start with the classic term loan.

A term loan is a kind of debt financing in which a provider lends your firm a certain amount of money for a set period of time in exchange for regular interest payments from your company.

If you choose term loan, you'll usually have access to a loan amount varying from £25,000 to £500,000 and the loan will usually need to be paid back in between one to five years. 

The interest rates on term loans are often reasonable, starting at 7% and going as low as 5%, but the exact amount you pay will depend on the lender, the size of the loan, and the company's credit history.

2. Short-term loans

The next kind of loan is the short-term business loan, which functions similarly to a term loan. If you choose a short-term loan, you'll still be paid the full loan amount, and be charged a rate of interest on this.

As their name implies, short-term loans are repaid in a shorter length of time and have higher interest rates than long-term loans.

This makes short-term loans a more expensive option for businesses, and if they're not able to pay back the loan, they could be charged, negatively impact their credit history, or have assets seized, depending on the loan taken out.

Typical short-term loan amounts are from £2,500 to £250,000, which need to be paid back in between three to eighteen months. Furthermore, unlike long-term loans, their interest rates often exceed 10% and usually start much higher.

You should still be told the annual percentage rate (APR.) of a short-term loan, even if it's paid back in less than a year.

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3. Equipment loans

Your savings may not stretch far enough for new business equipment, and that's where business loans can help.

In the case of equipment financing, a company borrows money to buy the necessary machinery it requires.

Equipment financing revolves around the piece of machinery or tool being purchased, so the loan's conditions are tied to that item.

In addition, the expected lifespan of the equipment will determine how long your loan term will be.

Also, the lender will take on less risk by lending to you since the equipment will serve as security for the loan. For this reason, the rates for financing your equipment will be reasonable, starting at only 8%.

4. Invoicing loans

Invoice finance is the next option on the list since it is a kind of self-secured loan. For company owners waiting on invoice payments, this form of financing can be useful. Invoice financing allows businesses to borrow up to 90% of an invoice's value using the document itself as security.

After your client pays the invoice in full, the invoice factoring provider will release the reserve amount to you, minus any applicable costs.

In addition, you can often get more favourable interest rates when you finance invoices. You'll pay factoring fees for invoice financing, and they are assessed as a percentage of the reserve amount kept by the financier.

The standard fees for factoring are 3% for the “origination” (or “advance”), plus 1% per week for the “delay” in payment (charged on the principal).

If you finance 90% of an invoice's worth, for example, and your client pays 90% of it, you'll be paid 90% less the origination charge and the factor cost, for a net payment of 10%.

5. SBA Loans

Next up, we SBA loans which are long-term bank loans with a government guarantee. The Small Business Administration (SBA) provides the guarantee.

When the SBA guarantees a portion of a loan made to a small firm, this means it is covering a percentage of the loan. If a borrower defaults on an SBA loan, the SBA will reimburse the lending institution for the guaranteed amount.

The guarantee reduces the risk for the lender in providing a loan to the small firm, making them more likely to do so. The conditions are also more favourable, including lower interest rates, larger loan amounts, and longer payment periods.

Furthermore, because of this partial guarantee, SBA loans can be one the most cost-effective option available to small businesses. They may be as little as £5,000 or as much as £5 million, with payback durations from five years to 25 years.

6. Business credit

The next option is the business line of credit. If your company is approved for credit, it will be given a credit limit from which it may make monthly withdrawals, much like a virtual credit card. Business lines of credit work similarly to business credit cards in that you only have to return the amount you actually use, rather than the whole amount you borrowed.

The main difference between a business line of credit and a business credit card is that you will be dealing with actual cash and not charged any additional fees for withdrawing cash.

Credit lines for companies may run anywhere from six months to five years and can be for any amount between £10,000 and over £1 million. However, you also need to factor in the interest rates, which can fall between 7% and 25% (or over), depending on the provider.

7. Merchant cash advances

This list concludes with a merchant cash advance. Lenders that provide merchant cash advances will look at your projected credit card sales as collateral. They provide your company with a quantity of money, called an “advance”, based on the value of this asset.

You will also need a credit card processing system in place before a loan will be paid out. This might be a cash register, Square, or PayPal. The lender will then begin automatically deducting a certain percentage of your daily credit card sales as payback for the loan they provided you with.

You'll continue making these daily payments until you've paid off your merchant cash advance in full, plus all accrued interest. But, you should know that merchant cash advances are often more costly.

The application process

Now that we've reviewed the basics of each business loan, let's take a look at how to apply for one of those loans. The eligibility criteria for applying for a loan vary depending on the loan and the provider, but here we've listed some general requirements.

1. 📘 General application requirements

The lender, your intended use of the cash, and your credit history are usually the most important factors to consider. Lenders' requirements for new loan applications are often conditional on the specific loan type sought. The following will usually be looked at when applying for a business loan:

Credit score

Lenders often look at your credit history and your business when deciding whether to accept your application, how much to loan you, and what interest rate to charge you.

A good or excellent credit score is usually required to get a Small Business Administration loan or a loan from a conventional bank, while a good or average score may be enough for a equipment financing or a company line of credit.

Earnings per year

Before approving a loan, most providers will require that your company generate a specific amount of money each year. This demonstrates your company's financial stability and capacity to make loan repayments in the future.

Age of business

Loans are more likely to be given to businesses that have been around longer. Lenders like to see a company with at least one to two years of operating before considering giving out money.

Debt-to-income ratio

Your debt-to-income (DTI) and debt-service coverage ratios (DSCR) may also be taken into account by potential lenders (DSCR). The debt service coverage ratio (DSCR) evaluates a company's ability to pay back its debt over a year based on the percentage of that year's net operating income that goes towards interest and principal payments.

Collateral

When you take out a secured loan, the lender will demand you to put up an asset (collateral) they may sell off if you don't repay the loan.

Individual guaranty

A personal guarantee is often necessary for certain loans and lending institutions since it protects the lender in the event of failure. When a company defaults on a loan, the borrower may demand personal repayment from the firm owner.

2. 📘 Term loan application

A business term loan is one of the best options available for small businesses but companies will need to have a good or excellent credit rating to get a higher loan amount.

You'll also need the following details when you apply for the loan:

  • Driver’s licence 
  • Financial statements
  • Budget and expenditure records
  • Expense and income statements
  • Your credit rating
  • Proof of ownership if the business

3. 📘 Short-term loan application

Short-term loans tend to be easier to get, but they also charge higher rates of interest. You'll also need to show the following documents when applying:

  • Driver’s licence or passport
  • Financial statements
  • Budget and expenditure records
  • Expense and income statements
  • Credit rating
  • Proof of business ownership

4. 📘 Equipment loan application

Equipment finance often requires a minimum of 11 months in operation, a good credit score, and annual revenue of £100,000.

If you and your company meet these criteria, you may apply for equipment financing; the next step is to compile the following materials for submission:

  • Driver’s Licence or passport
  • Financial statements
  • Credit rating
  • Corporate income tax returns
  • Proof of business ownership

5. 📘 Invoicing loan application

Invoice financing differs from most other sorts of loans in that there are no minimum credit criteria for applicants; but you'll need the following to apply:

  • Driver’s Licence or passport 
  • Financial statements
  • Proof of business ownership
  • Details of due invoices

6. 📘 SBA loan application

To qualify for an SBA loan, your firm and you must have been in operation for at least two years, have a good credit score, and have annual revenues of at least £100,000.

When applying for a Small Business Administration loan, you'll need to have the following materials on hand:

  • Driver’s licence or passport
  • Financial reports
  • Company balance sheet
  • Financial statements
  • Tax returns
  • Marketing strategy
  • Proof of business ownership

7. 📘 Business loan application

There is no minimum credit score requirement for a company line of credit, just as for invoice financing.

You'll also need the following:

  • Driver’s licence or passport
  • Financial reports
  • Company balance sheet
  • Financial statements
  • Credit rating
  • Company tax reports 
  • Tax returns

8. 📘 Merchant advance loan application

Finally, merchant cash advances have one of the simplest application and approval processes among all forms of company finance. There aren't many prerequisites for a merchant cash loan, but most state that the company needs to have been operating for at least five months in operation, and have £50,000 in yearly sales.

You'll need to provide the following:

  • Driver’s licence or passport
  • Financial reports
  • Credit rating
  • Company tax reports 
  • Proof of ownership

Repaying your business loan…

Repayment terms will vary from loan to loan and while short-term loans often require weekly or daily payments, longer-term loans are usually paid back monthly.

When you finance a piece of equipment, the loan terms are often as long as the expected life of the equipment you purchase.

With SBA loans, repayment periods begin at five years and go up to twenty-five years, depending on the lender.

While business lines of credit typically have a longer repayment period of anywhere from six months to five years.

Lastly, merchant cash loans are repaid by daily draws from future credit card transactions (if daily sales are made).

Remember that before agreeing to the terms of a loan, it's important to read the agreement carefully.

Our conclusion…

Every business is different and that's why taking out a loan takes serious consideration, so you can find the right one for your company.

There are lots of options available, but you also need to consider how much the loan will cost you and how long you have to pay it back. Business loans can be a great way to get access to cash, but it's important to remember that if you won't make the repayments, the loan is going to push you into more debt, with financial penalties for missing payments.

Related guides:

How Do Business Loans Work? FAQs…

How hard is it to get a business loan?

How big a business loan can I get?

How much collateral do you need for business loans?

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