The right business loan can help you get the capital you need to start a new venture, expand a current business, gain access to working capital and more. But not all business loans are created equal, and understanding how each type of loan works can give you a better idea of which one is the right fit for you and your business.
If you’ve ever wondered, “How do business loans work?” this guide can help.
How do business loans work?
Business loans are capital offered by lenders to businesses. In exchange for this money, lenders require repayment of the principal with interest and fees added to it. Usually, business loans require regular payments on a set schedule, but repayment terms and interest rates can vary quite a bit.
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Business loan requirements
Regardless of which type of business loan you apply for, you’ll likely see many of the same requirements to qualify and get approved.
Personal and business credit scores
If your business has an established credit history, lenders may run a credit check to see how the company has managed credit in the past. A poor business credit history could make it difficult to get approved for inexpensive financing.
If your business doesn’t yet have a credit history — and sometimes even if it does — lenders will also check your personal credit score. This is primarily because many business loans require a personal guarantee that you’ll pay back the debt with your personal assets if your business can’t make payments.
If you have good or excellent personal credit, lenders are likely to assign more value to your personal guarantee. If, however, your personal credit score is considered poor or fair, it could pose more of a risk to the lender, and you may have a hard time getting approved.
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While your credit scores are a good indicator of your overall credit health, they don’t tell the whole story. In addition to checking your credit score, business lenders may also check your credit reports to see if there are any tradelines to be concerned about.
If you have any missed payments, a bankruptcy or foreclosure, or an account in collections, the lender may take that as a sign that you might not repay the debt on time. On the flip side, if your credit report shows a history of responsible credit use, it can help your case, even if your credit score isn’t perfect.
Time in business
Starting a business is a risky venture, so many business lenders don’t provide certain types of loans to newer businesses. On the flip side, some business loans are relatively easy to get, even if your startup is brand new.
To qualify for term loans, SBA loans and business lines of credit are traditionally reserved for businesses that have been around for two or more years. You can, however, typically get trade credit, merchant cash advances, invoice financing and collateralized loans like equipment financing from the beginning.
Many business lenders will require detailed information about your financials, including cash flow statements, profit and loss statements, a balance sheet and projections for the future. The stronger your financial situation, the easier it will be to qualify for a good business loan.
Not all business loans require collateral, but many of them do, especially ones with lower interest rates. Lenders will typically want a physical asset, such as real estate or equipment. If you don’t have anything of that nature, you may have a hard time getting approved for some loans.
How does business loan repayment work?
The type of business loan you choose also affects how you’ll end up repaying the debt. There are three main types of business loan repayment options: revolving, installment and cash flow.
Business credit cards and lines of credit are the two primary types of revolving business loans. When you open an account, you’ll get a line of credit that you can access whenever you need it. As you use your card or draw from your line of credit, it reduces your available credit. Once you pay back the amount you’ve borrowed, however, that amount becomes available credit again.
As long as the account is open — and during the draw period of a line of credit — you can continue to borrow, repay and re-borrow up to your credit limit.
Most business loans are installment loans. Instead of getting a revolving credit line, you receive the full amount of the loan upfront and pay it back in equal installments. This way, there’s a set repayment term, typically with fixed monthly payments.
A cash flow-based business loan functions similarly to an installment loan in that you receive the full amount of the loan upfront. However, repayment is based on your cash flow rather than a set repayment term.
For example, a merchant cash advance offers capital based on your debit and credit card sales. To repay the debt, you may give the lender a cut of your future debit and credit card sales. With invoice financing, you can get financing based on an accounts-receivable invoice, which you’ll repay when you get the cash payment from the invoice.
How do business loans work by type?
With so many types of business loans on the market, here’s a breakdown of how each one works to help you decide which one is right for you.
There are three types of term loans you may come across: long-term, intermediate-term and short-term. Long-term and intermediate-term are typically traditional bank loans and require at least a couple of years in business and strong revenues. The repayment terms, which are based on monthly installments, usually range from a few years up to 10 years.
Long-term and intermediate-term loans typically offer low interest rates relative to other business loan types.
Short-term loans, however, may be available to new business owners with little to no time in business. These loans are typically due within a year and often charge high interest rates. While it may be tempting to use a short-term loan for a quick fix, consider the cost before you apply.
SBA loans are business loans that are partially insured by the U.S. Small Business Administration. There are several types of SBA loans, including loans for real estate, working capital, expansion and more. New business owners can even qualify for microloans of up to $50,000 to get their business off the ground.
SBA loans tend to have strict requirements, and most require two or three years in business at a minimum. Because loans are provided by individual lenders instead of the SBA, eligibility requirements can vary from lender to lender.
They can also take a long time to get approved and receive funding. If you qualify, though, SBA loans come with low interest rates. As far as repayment goes, you may have the option to choose between an installment loan and a revolving line of credit. Be sure to take the time to compare each option to pick the right one for you.
Business lines of credit
As previously mentioned, business lines of credit are based on a revolving credit line. The repayment is typically separated into two phases: the draw period and the repayment period.
During the draw period, you can use your available credit, repay it and use it again. During this time, you’ll typically have to make interest-only payments. Once that period ends, however, and the repayment period begins, the current balance will be amortized, and you’ll no longer be able to take draws from the credit line.
This setup gives you a lot of flexibility to access financing when you need it rather than needing a plan to use a lump sum payment from an installment loan.
Most business lines of credit require solid financials and time in business, but some lenders may be willing to work with newer business owners.
Business credit cards
Like business lines of credit, business credit cards are based on a revolving line of credit. The main difference is that business credit cards don’t have any set repayment terms at all.
In addition to providing a revolving credit line, business credit cards also typically provide business owners with other benefits, including rewards, introductory 0% APR promotions and other perks. However, most of them charge relatively high interest rates, which, combined with no set repayment terms, can keep you paying interest into perpetuity.
If you’re planning to get a business credit card, a good practice is to pay off the card on time and in full each month. This allows you to get all the benefits of the card without paying any interest at all.
If you’re a new business owner, trade credit can be an excellent way to get your foot in the door with credit. This type of business loan involves setting up a credit arrangement with a vendor or supplier.
Instead of paying cash on delivery, trade credit allows you a set period, typically 30 days but sometimes longer, to pay the invoice without any interest. In some cases, you may even be able to get a discount on the goods or services the vendor provides if you pay early.
Trade credit isn’t always easy to get, and you may need to establish a good relationship with a vendor before you can request the arrangement. If you do, some vendors may choose to report your monthly payments to the commercial credit bureaus.
Invoice financing involves putting up an invoice from accounts receivable as collateral for a loan. Depending on the lender, you’ll typically be able to borrow up to 80% or 90% of the invoice amount — though some lenders may offer up to 100% financing. You’ll then repay the debt when you receive the payment for the invoice.
Because invoice financing is collateralized, it’s possible to get approved without a lot of time in business. However, you can typically expect to pay a high interest rate.
Also, note that there’s a similar type of financing called invoice factoring. Invoice factoring isn’t technically a loan because it involves selling the rights to the invoice to a third party rather than borrowing against it.
Invoice factoring doesn’t require any credit or time in business, but you’ll typically get less cash in the sale than you would with invoice financing, so it’s only worth considering as a last resort.
Merchant cash advances
A merchant cash advance is one of the easiest business loans to get but also one of the most expensive, charging as much as triple-digit interest rates.
As the name suggests, this financing option provides an advance on future merchant debit and credit card sales. In return, you’ll typically repay the debt through a percentage of your future sales rather than in equal installments.
It’s important to keep in mind that while merchant cash advances are relatively easy to get, that doesn’t mean that just any business can get one. Because a merchant cash advance is based on future debit and credit card sales, you may not have much success getting one as a new business owner without such sales.
If you’re looking specifically to borrow money to purchase a vehicle or other type of equipment for your business, an equipment loan is likely your best bet.
Equipment loans are typically installment loans, and you’ll be required to put up the asset you’re purchasing with the loan as collateral. In many cases, you may also need to put some money down on the loan.
Because equipment loans are secured by the asset you’re buying, they don’t represent a lot of risk to lenders. As a result, they typically come with relatively low interest rates and are available even to new business owners.
That said, equipment financing is often a long-term commitment, so it’s important to consider how necessary it is before you apply.
Real estate commercial loans
As with equipment loans, real estate commercial loans are a specialized form of credit designed to be used for real estate transactions.
For example, you may apply for a mortgage-type loan to purchase a property, a short-term hard money loan from individual lenders to invest in and flip a property, or a construction loan to build on existing land.
Real estate commercial loans are long-term commitments, with some lenders offering up to 30 years to repay your debt. However, they tend to charge low interest rates because they’re often secured by the property you’re purchasing or building.
That said, you may need to have solid financials to convince a lender that you’re a safe bet for such a long commitment.
How to pick the right loan for your business
There are many different types of business loans, and each works a little differently. To find out which one is best for you, start by considering where your business stands. If it’s a brand new startup, you’ll be limited to just a few options, such as business credit cards and invoice financing.
If, however, you’ve been in business for years and have strong financials, you may have your pick of any type of loan.
As you compare different options, think about what you need out of a loan. For example, do you want a revolving line of credit or a lump-sum payment? Would you prefer installment payments or a cash flow-based payment? How sensitive are you to interest rates, and is it worth it to wait to borrow until you’re in a better financial position?
As you consider all of these factors, it’ll be easier to narrow down your choices. Once you decide which type of loan is right for you, take some more time to compare different lenders that offer that loan. Because each lender has different creditworthiness criteria and loan terms, shopping around will improve your chances of getting the lowest interest rate and best terms possible.
Pro tip: What you don’t know can kill your business
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