- Posted on
- Riley Draper
Running a successful business often comes with many unexpected costs.
If you are a new business owner, you may be curious about getting extra financing to help run your operations more smoothly. But how do business loans work? What can you expect during the loan process? In this article, we will cover the whole business loan process from start to finish.
Business Loans at a Glance
Business loans are either a lump-sum payment or a credit line provided by banks, credit unions, or online lenders to a business owner. These financial institutions offer loans based on the likelihood you will be able to pay the money back over a stipulated amount of time, including extra interest and fees.
If you are unable to pay back the money, there will be consequences. But the kind of consequences will depend on whether you have a secured or unsecured loan.
- Secured loans: If you apply for a secured loan, your lender will require collateral. In this case, the lender would have full rights to keep the asset if you can’t pay back the loan. Examples of possible collateral could be real estate, equipment, cash, or an investment.
- Unsecured loans: This type of loan will not need any collateral. But in exchange for the money lent, you will be agreeing to accept personal liability if you are unable to pay back the loan. As a result, you may see a drop in your credit score, wage garnishment, and possible lawsuits. You may also have trouble getting loans in the future.
What exactly do you need the money for? Knowing the use of the money will help you and your lender determine what type of loan you need. Typical uses for business loans include things like:
- Startup costs
- Working capital
- Consolidating debt
- Buying equipment
- Buying inventory
- Business acquisitions
- Expansion of the business
- Commercial real estate loans
- Remodeling commercial real estate
The Business Loan Process from Start to Finish
Now that we have an idea of what business loans are, next we will find out how business loans work. Although the business loan process will have varying steps depending on your lender, there are specific steps that usually occur. Let’s explore a typical business loan process.
Step 1: Prepare a Business Plan
Are you applying for a traditional term loan? Then along with your loan application, you will probably be asked to submit a business plan. A business plan is a document that lays out the objectives of your company and how you plan to meet those objectives.
This document will help the lender determine whether or not your business is viable. Before you meet with your lender, be sure to create your business plan. It should include the following:
- Executive summary: Briefly describe why your company needs the money. Provide a brief background.
- Company description: Describe your client base and how you want to connect with them. What exactly will your company be doing?
- Operational plan: The operations plan should describe how you intend to carry out your company goals.
- Services: Detail the services you plan to carry out for your potential customers. What needs are you meeting for your clients? Explain how this is a profitable mode of income, including detailed pricing.
- Market analysis: Talk about how you have a competitive advantage in your target market. Give a competitive analysis and price comparisons.
- Management and personnel: Explain how you will hire your management team and employees.
- Sales and marketing strategies: How do you plan to reach new customers? Include your sales strategy. Will you use social media or other marketing strategies to reach your target market?
- Financial projections: Try to predict your state of finances five years ahead.
- Funding request: Come up with a specific amount of money you need for business financing. Show the lender how you determined that amount. Include your assets and how much you will be contributing to pay for the needs of your company.
Make sure to also provide your lender with financial statements such as tax returns, bank statements, profit and loss statements, and any other financial forms they request.
Step 2: Submit Your Loan Application
Along with your business plan, you will be asked to fill out a loan application. Although loan application forms vary between lenders, there is some standard information all lenders will typically ask for, including:
- The annual revenue of your business
- Names and social security numbers of anyone with an ownership interest
- Banking relationships with any financial institutions
- Existing loan information
- Any collateral you are willing to put up
- Loan amount
- Loan type
Types of Business Loans
The type of business financing you get should be based on your business needs. Here are some of the most common types of loans for small business owners:
- Small Business Administration (SBA) loan: SBA loan programs are backed by the U.S. Small Business Administration. This means that a portion of the money is secured by the government, making it a lower risk for the lender. It also means possible lower interest rates. Typically businesses that are unable to get a loan by other means can be given an SBA loan. The qualification process may take longer than others, however. If you are interested in microloans of up to $50,000, SBA’s microloan program could be a good bet. But for entrepreneurs needing more funding, the SBA’s flagship 7(a) loan program offers financing that borrowers can use to start businesses.
- Working capital loan: Working capital loans are often short-term loans. It is meant to help cover day-to-day business expenses like payroll or inventory costs. It can help those businesses that have hit a slow period in sales, like seasonal businesses. The terms of working capital loans will vary on how much risk you want to take on. Typically, if you take on a loan that is easy to qualify for, it will probably come with higher interest rates and fees. This puts less risk on the lender and more risk on you, the borrower.
- Equipment financing: Oftentimes businesses don’t have the extra money lying around for necessary operational equipment. This could include anything from electronics or large manufacturing machinery. You will likely need to add a down payment, though the lender may finance up to 100% of the costs.
- Term loan: Business term loans are repaid over a set amount of time. The term is often up to 10 years. The loan terms, including how much you can borrow, and the annual percentage rate (APR) will depend on the history of your business, annual revenue, and credit history (both personal and business). Oftentimes online lenders are more lenient for those with bad credit than traditional bank loans. Additionally, the funding can also come more quickly.
- Business line of credit: If you are unsure how much you will need to borrow upfront, you may consider getting a business line of credit. You will be able to access a certain amount of money as needed, just like business credit cards. As you repay the money throughout the draw period, you can reuse the credit limit. You will then only owe the interest on what you have borrowed, not on the amount you were approved for. Once the draw period is over (usually 12-14 months), you will begin the repayment period which will include interest on the money you’ve borrowed.
- Invoice factoring: For startups and new businesses, invoice factoring could be a wise choice since no credit has been built up yet. With this type of financing, the business would sell its outstanding invoices to a factoring company. You will be advanced part of the uncollected invoices by the factoring company, then they will be in charge of collecting those outstanding invoices. After the money has been collected, the company will pay you the rest of the balance. However, they will also charge factoring fees for the service, which is usually between 0.5% to 5% each month the invoice is left outstanding. If you aren’t interested in working with a factoring company, consider invoice financing instead. This is a loan or line of credit from a lender that is backed by your outstanding receivables.
Step 3: The Lender Approves or Denies the Application
After you’ve submitted your business plan and loan application, your lender will review all the documents, including your credit report. The lender will expect that your business meets the minimum eligibility requirements for the type of financing you are trying to qualify for.
The process of examining all of your finances for loan approval is called underwriting. This will determine how much risk you pose to the lender. Some requirements lenders look for include things like:
- A good credit score. This can include both your business credit score and personal credit score
- Enough annual revenue to support debt payments
- The business is already in operation (a new business may have a harder time getting a loan)
- A manageable debt-to-income (DTI) ratio. This compares how much you owe each month with how much you earn
- A manageable debt-service coverage (DSCR) ratio. This measures how much cash flow your business has to pay its debts
- Collateral for secured loans
- A personal guarantee
Based on all the information received, the lender will either approve or deny your business loan application. This ends the application process.
Step 4: The lender Will prepare The Loan Agreement
If you are approved, the lender will put together a package of documents stating the repayment terms of the loan. This set of documents is called the loan agreement. On your loan agreement, the loan costs will be laid out for you, including repayment schedules, as well as all the terms and conditions of the loan.
Step 5: The Loan Authorization Is Finalized
In the loan agreement, there may be some terms and conditions you must meet before the loan authorization is finalized. The terms of the loans can apply to things like finalizing any changing business ownership, obtaining business insurance, or making the lender your primary bank for the loan duration. Once the stipulated terms and conditions are met, the loan will be closed.
Step 6: The Borrower Receives The Loan Disbursement
Next, you will receive the loan proceeds in the way that has been stated in your terms and conditions. Your loan agreement will tell you what amount you will get, and when. Before you apply for your loan, make sure you are aware of when the funds can be disbursed.
Ask your lender when you can expect to receive the proceeds. Sometimes you may not be able to receive the funds as soon as you’d like, so it’s a good idea to get a timeline from your lender.
Step 7: The Borrower Pays The Loan
The loan agreement will have laid out how much your payments will be, when they will start, how to pay, and when the loan will be fully paid off. This could mean daily, weekly, or monthly payments. Your payment will include part of the principal balance and interest payment.
Be sure you know how much interest you will be paying ahead of time. If you want to pay the loan back early by putting more money toward the principal, you may be able to do that. However, you need to check with your lender or review your loan agreement to see if there are any early repayment fees.
Step 8: The Balance is Paid in Full
All paid up? This means the loan process is complete! If there was any collateral on the loan agreement, the liens will then be released. This means the lender no longer has a claim against your property. After the balance is paid in full, the lender will mark your note as paid off. Then it is time to celebrate!
Running Your Business Smoothly With Less Stress
Now that we’ve answered the question “How do business loans work?” you will know what to expect. Are you ready to find the right loan for your small business? But if you aren’t up for traditional bank loans’ strict eligibility criteria, the lengthy application process, and possible collateral risk, there are plenty of other options…like us!
Here at Coastal Kapital, we offer equipment financing, working capital loans, and SBA financing options. We would be happy to help you run your business more smoothly with less stress.If You Like Please Share It: