Common Pitfalls in Business Loans and How to Avoid Them

Common Pitfalls in Business Loans and How to Avoid Them

Common Pitfalls in Business Loans and How to Avoid Them

If you’re hoping to launch a new product, expand your workforce, or upgrade equipment, a small business loan can offer leverage and wiggle room for even the most cramped budget. For those who qualify, it can add liquidity in as little as 24 hours, as most business loans have online applications. Unfortunately, the application isn’t always the most difficult part of the process. See what struggles other business owners have experienced when getting funding and what you can do to avoid some of the less desirable consequences.

1. Collateral

Many business loans require you to put a little skin in the game – usually in the form of collateral. Securing a loan through your own home or property, liquid business assets, future invoices, or even the equipment paid for with the loan funds are all things a bank may ask for before coughing up the cash you seek. Collateral amounts will vary by the type of loan you are requesting; more traditional lenders usually require it more frequently. The loan amount is also a factor. If you plan to go with a specifically-branded small business loan in the tens of thousands of dollars, expect to show a list of things you’re willing to give up if the loan isn’t paid back satisfactorily.

2. Liquidity

Once you get the loan, it can feel incredibly freeing, especially if you’re using the money to pay off high-interest debt or scale your business in a way that can increase sales down the road. Not all loans give a business financial breathing room, however; money borrowed to buy tangible assets (such as real estate or fleet vehicles) will add to your monthly expenses. Loan payments can cause strain on an already tight profit and loss sheet and reduce your liquidity significantly. Money used to pay back small business loans is money you can’t use for other things.

3. Credit Score

Many of the online small business loans will let you peek at the amount and rate you qualify for without resulting in a “hard” inquiry on your credit report. To follow through with the loan process, however, you’ll need to permit bank access your credit history, and this will almost always ding your score by a few points. Add in a creeping total debt load, and this new loan has the potential to put your creditworthiness in a worse place than it was before you applied. If you’re looking to maintain good credit for an even bigger loan or merchant credit down the road, you’ll want to utilize loans and loan applications sparingly.

(One silver lining to taking out money, however, is if it adds to the variety of loans you’ll have outstanding. A good mix of revolving and traditional credit lines can put your score in a sweet spot compared to just having one or the other.)

4. Equity

Unlike credit cards, which let you access the full line of credit at any point in repayment, small business loans don’t let you borrow any more until you’ve paid off what you initially borrowed. A $10,000 business credit card stands as an option to borrow as little or as much as you want as long as you never go above the limit. If you want more cash from a small business loan, you’ll have to pay off the original note, then see if you qualify for a second, separate loan (which you may or may not qualify to get.) Small business loans are, for that reason, not ideal for those needing the most flexible lending choice.

5. Rules on Business

Very few loans for consumers will tell you what to do after you cash the check. They simply want to be paid back according to terms of the banknote. A small business loan, however, may come with more strings attached. A bank may require a business to check in with the lender and update on how the business is doing, and if debt to available debt is in a good ratio. Red flags that indicate the business isn’t doing well could cause the bank to call off the loan and order repayment immediately. For this reason, it’s wise to read up on all the requirements a bank demands before borrowing money. You may not find the terms agreeable for your business’ long-term goals.

6. Approval

Finally, this wouldn’t be an accurate list of pitfalls and setbacks without mentioning how hard it can be to get a small business loan in some instances. While some lending platforms, such as those for crowdfunding and P2P lending, can offer shorter, more streamlined ways to get funds, traditional loans still ask applicants to give up a lot of financial, tax, and marketing plan info to get in the door. Most business loans ask that you be profitable, have two to three years of sales or profit records, and are willing to demonstrate continued growth for the life of the loan. For a new startup, this can be almost impossible. This is why some startups choose to look into an alternative method of funding – or perhaps a microloan – instead.

With so many obstacles to overcome, does it still make sense to apply for a small business loan? The answer is that it depends. The Small Business Administration reports some pretty big numbers for cash given out to businesses, and not all of it went to established, profitable companies. Over $219 million is earmarked for companies less than two years old in 2019, and $341 million is destined for brand new startups.

Getting even a small portion of that money could make a big difference for your venture. By preparing for your loan application in advance, researching all the options available for your industry, and being careful about the types of debt you take on, it’s possible to make the risks well worth the rewards. Many businesses are taking on new debt to fund their dreams. Will you?

This article was originally written on December 10, 2018 and updated on February 2, 2021.

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