When you need financing for your small business, a loan may seem like the obvious choice. However, small business loans come in different forms, and one may be more useful in furthering your goals than another. Understanding the basics of small business loans is the first step in choosing the financing option that best fits your needs.
How Small Business Loans Work
Small business loans are a form of debt financing. You borrow money from a lender and agree to repay it, with interest, over a preset period of time. Unlike with equity financing, you don't have to offer any ownership stake in your business. You may, however, have to give the lender collateral to secure a small business loan. Some small business lenders also require you to offer a personal guarantee or agree to a UCC lien as a condition of obtaining a loan. Your ability to qualify for a small business loan hinges on several factors, including:
- The length of your operating history
- Your annual revenues
- Your personal and business credit scores
These same factors also influence how much you're able to borrow and the interest rate you'll pay (and, consequently, your APR). Depending on the type of small business loan you apply for, you may have anywhere from three months to 10 years to repay what you borrow.
Types of Small Business Loans
Small business loans aren't all the same. Some are designed for short-term needs, for example, while others are geared toward helping your business expand. Here's a brief rundown of how different small business loans compare:
- Term loans — A term loan is similar to a mortgage or a car loan. You borrow a set amount of capital and repay it to the lender, according to the schedule they determine. Term loans can be short-term or long-term.
- Working capital loans — Working capital loans typically feature shorter repayment terms and lower borrowing limits than term loans. They're designed to finance a small company's everyday operations.
- Inventory loans — Inventory financing can be helpful if you need to purchase inventory quickly and don't have sufficient cash. The inventory you purchase can be used as collateral for the loan.
- Equipment loans — Equipment loans are exactly what they sound like: loans for the purchase of equipment. A term loan could be used for the same purpose, but an equipment loan may give you a longer time frame to pay it off.
- Small Business Administration loans — The Small Business Administration (SBA) doesn't offer loans directly; instead, it works with businesses to connect them with lenders. The most appealing aspects of SBA loans are high borrowing limits and low interest rates.
- Invoice loans and merchant cash advances — Invoice loans allow you to borrow against your outstanding invoices, while merchant cash advances let you borrow against your credit and debit card receipts. Both use a factor rate to calculate the cost of financing and they tend to be more expensive than other loan options.
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