Businesses require capital to fund startup expenses and growth. Loans provide a way to secure access to funding by incurring a debt that the company is obligated to repay. Several types of business loans are available, each suitable for different scenarios.
Secured vs. Unsecured Business Loans
There are two broad categories of business loans: unsecured and secured.
Unsecured loans have no collateral pledged as a secondary source and typically have a higher interest rate than secured loans. This type of business loan is more difficult to qualify for than a secured loan, as profitability and a successful track record are required.
Unsecured loans don't automatically put a business owner's personal assets in jeopardy should the business have to default on the loan, but certain instances do potentially expose the owner to personal liability. Be aware of the risks involved.
Secured loans, which tend to have lower interest rates than unsecured loans, require collateral pledged in case the business cannot fulfill its payment obligations. Bank appraisals of collateral are usually conservative, so an independent appraisal and detailed records for any property used as collateral might be worthwhile.
How Lenders Decide
Lenders examine the default risk associated with each loan application, which includes looking at credit score, revenue, tenure in business, collateral, and other factors. If your lender is confident that your business can repay the funds, and considers you a low risk based on the criteria, she may grant you an unsecured loan. Otherwise, a secured loan may be your only option.
This is likely the loan type you're most familiar with. Your business borrows a set amount of money, to be repaid with interest in equal monthly payments over a set amount of time. Installment loans (also referred to as term loans) tend to have the lowest interest rates of the various types of business loans.
Installment loans are usually made for larger amounts and longer terms than other types of loans, and can be secured or unsecured. They may be fairly difficult to qualify for, but are a good option if you are looking for a lump sum for a specific reason. The shorter the term, the lower the default risk to the bank, so expect the interest rate to be adjusted accordingly.
This type of loan typically requires fixed payments of principal and interest due monthly, regardless of your company's cash flow. These nonnegotiable amounts should be factored into your financial projections. If uneven or lumpy cash flow is an issue, other loan options that offer flexibility with regard to payment amounts may be a better option.
Equipment loans are installment loans specifically designed to help finance vehicle and equipment purchases. Secured by the asset, terms for this type of loan typically range from two to six years, depending on the collateral.
Lines of Credit
A line of credit grants a business the opportunity to access cash up to a specific amount for almost any reason. This is a facility that business owners often set up pre-emptively in case of a cash flow shortage or emergency situation.
Most banks fund the capital requested from a line of credit through the borrower's business checking account. The borrower can then draw cash from the company's checking account via a debit card.
These unsecured loans are not intended for equipment or real estate purchases. They are short-term (up to one year), with low interest rates. Interest begins accruing immediately upon draw. Most businesses have the option of paying only interest monthly, but it is highly recommended that you make payments on the principal regularly.
To apply for a line of credit, lenders will want to see tax returns, cash-flow, and financial statements.
Like installment loans, balloon loans are for a specified amount and can be secured or unsecured. Interest is paid monthly, with a lump-sum principal payment (the 'balloon' payment) due on the last day of the term. Balloon payment loans are a best fit when a company must wait for a large payment from a customer, or products.
These are the smallest loans, intended for launch or expansion. Microloans refer to loans that are below $50,000. They average about $13,000 and are originated through an intermediary. They may be secured or unsecured. Interest rates typically run between eight and 13 percent. While repayment terms may vary, the maximum term length is six years.
The Small Business Administration (SBA) has a number of loan programs specifically for small businesses. Options include: general small business loans, microloans, real estate and equipment loans, disaster recovery loans and more. Small business loans for women and minority-owned businesses can be good resources if you are eligible.
Small business loans may be secured or unsecured, depending on the program. The SBA does not loan money directly; you would need to apply with an SBA lender to take advantage of one of their programs. Contact your local SBA District Office to get program details.
Interim loans, also known as bridge loans or gap financing, are usually applied to make payments to contractors and maintain operations during a buildout of new facilities. A portion of the upcoming mortgage is typically used to repay the interim loan, and funders will want to documentation for the source of repayment to assess risk involved.
These loans are usually secured and come with relatively high interest rates and equally high closing costs, aside from the fact that they are short-term. For these reasons, this option is right for only a select few businesses.
Interest-only loans can be secured or unsecured and vary by term. For the first five to seven years, only interest is paid. After the interest-only period, the required monthly payment increases to include the loan principal plus interest. Payments may increase dramatically after the interest-only period.
Interest-only loans are not a good fit for many businesses. They may be suitable for situations in which there is uneven cash flow, or a substantial increase in income is expected after the first few years.
Diversity Funding Options
Loans are a good way to get funding for small businesses, though they are not the only option. Private investor funding, venture capital, and increased cash access through a business credit card are also possible ways to acquire capital to help fund a prosperous (and profitable) venture.