How Does A Small Business Loan Work?

A small business loan is the best method of financial support that doesn’t involve signing over any of your business, so you (and any other shareholders) remain in total control, just receiving a lump sum of money to support you on your way.

By providing you with the cash that your business needs to get started or grow larger, whichever lender you choose will make their money in charging interest on the loan they’ve given, calculated as a percentage of the principal or initial amount.

The amount of time you have to pay it back and how much interest you’ll pay varies.

There are several different kinds of loans to understand, all of which can be offered to a small business, so let’s go through all of them individually: 

How Does A Small Business Loan Work

Term Loans

These are the most commonly given business loans, and it’s likely what you were envisioning when you decided to get one: if you qualify, you and the lender will agree on an amount of money that will be paid back with interest.

Payments are scheduled monthly and given on agreed dates, following a pre-established and unamendable repayment schedule. You’ll typically get a considerable amount of money via a term loan, from say twenty thousand to half a million dollars.

As they’re very rigidly outlined, you’ll usually get a much longer than average period in which to pay them back, anywhere from a year to five years depending on the amount. Do be aware though, that you’re paying interest continuously!

However, the rates of interest on a term loan are typically much fairer than others, which means you could be paying back less than 10% interest if the rates fall in your favor - provided you didn’t get it from the bank, that is!

Short-Term Loans

Much like the above process, a short-term loan is a set amount of money agreed upon by both you as a business and your lender, which is paid off over time and will generate interest as you do so.

As the name suggests, though, these are often for much smaller amounts of money, and you have a lot less time to pay them back, which results in much higher interest rates than the more conventional term loans.

Typically between a couple of thousand and around a quarter of a million dollars, repaid in approximately three months to a year and a half, depending on the terms you agree on. If you only need a little money to help your business, it’s very useful. 

However, the tighter nature of their terms makes them more difficult to pay off, and as a consequence, it can result in a monthly, weekly, or possibly daily payment being required, which for a small business can prove very difficult.

Likewise, the interest rate on a short-term loan is never going to be lower than ten percent; often, your rate will be calculated as a “factor” rather than a percentage, which is a decimal number you multiply by the principal amount of your loan.

As opposed to the more traditional APRs that are usually provided, this is a better estimate of how much you’ll be looking to pay back. There are handy calculators that convert factor rates to APRs if you’re struggling to understand!

It’s worth pointing out that even though the interest rate is higher on a short-term loan, because you have less time to pay it back, there’s not much time for interest to accumulate, so you could end up repaying less than you would for a term loan.

Small Business Association Loans

Although there are many different places to get a loan from, for the sake of your business it’s best to stick with those who are recommended by the official, government vetted Small Business Association (SBA) for the sake of your business.

They can be a lot trickier to understand, but they’re also typically cheaper to pay back in the long run if you can get your head around it. Essentially, they’re a term loan that’s offered by banks as well as being somewhat funded by the SBA.

Essentially, they “partially guarantee” your loan, which means they take responsibility for a part of the financial burden; if you end up not being able to afford your repayment to the lender, the SBA will pay the agreed-upon amount for you.

This means that the lenders aren’t putting as much on the line to offer you the loan, so they’re less reluctant to pay out to small businesses without guaranteed sources of income. 

Plus, the interest APRs are typically lower, with more money offered in general - from as little as a few grand to as much as a few million dollars! - and the repayment terms are even more generous, being at least five years, and up to twenty five!

Interest rates for an SBA loan have been known to dip right down to 6.5% at times! That’s a ridiculous saving when it comes to paying back the money you owe, so it’s well worth the hassle of working through their lengthy terms and conditions.

Invoice Financing Loans

This kind of loan is offered to small businesses who are waiting on invoices to be paid out - lenders offer you an advance on this payment, which you can then repay as soon as the invoice has been processed and money added to your account.

Anywhere up to 90% of your invoice’s value can be paid out as a loan and the existence of the invoice itself actually serves as collateral. Whatever is left of your invoice after the loan is paid is held back by the invoice factoring company.

Once the customer has paid out the invoice in full and they have processed everything, they will take a fee for their services before returning the remaining funds to your account for you to spend as you please.

As the invoice counts as collateral, the interest rates are lower than average, usually a 3% origination or advance fee for the invoice, as well as a 1% factor fee for every week that the invoice is not paid, calculated according to the principal loan amount.

Confused? Let’s try explaining it this way: say you get a loan for 90% of the value of the invoice you’re owed. Your lender will give you this money, and the invoice is taken over by the factoring company the lender works with.

Once the customer has paid your invoice back to them in full, said factoring company will pay out the 10% of it that you did not borrow initially, minus their processing fees and any interest. 

Equipment Financing Loans

Much as the name suggests, an Equipment Financing loan is given specifically by a lender so your business can pay to get a piece (or multiple pieces) of equipment that you require in order to operate.

This is what’s called a self-secured loan, so the equipment that is purchased with the loan automatically becomes the collateral for the loan itself. Essentially, if you fail to make repayments, they won’t take anything from you except the equipment.

Likewise, the terms of the loan are fully dictated by the equipment that you require. You can get a loan for part of the equipment, or the full amount of its costs. The terms of repayment are also determined by how long the equipment should last.

For instance, if you purchase say an industrial vacuum cleaner that should last up to ten years according to the warranty, you’ll have ten years to pay back however much of the total cost you borrowed to pay for it. 

As a result of it being its own collateral, the interest that you pay on the equipment loan will be considerably lower than usual, because the lender is not risking very much by providing you with the money.

In Summary…

So, just to round things up - regardless of where you get it from or how much you apply for - a small business loan is a pre-agreed upon amount of money you’ll receive from a lender, either via the SBA or the bank, for the sake of your business. 

You have a set time to pay it back, either in months or years depending on the nature of the loan, and interests vary based on how much you borrow and how risky it is. It’s pretty straightforward once you get your head around it!