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Business Loans: Your Complete Guide to Financing

| MoneyRates.com Senior Financial Analyst, CFA
min read

business-menMost companies couldn't get by without using business loans from time to time.

Knowing the right way to use these loans can boost your profits and might even make the difference between your company's success or failure.

Find personal loans for business

Business Loans for Every Purpose

Not all forms of business financing are the same. They are like the ingredients in a recipe - you need to know the right ingredients to use depending on what you are trying to make.

In the same way, different types of business financing exist because companies have different needs at various stages of their life cycles. This article will review 20 types of business financing, and list them according to which of three situations they might be the best fit for:

  1. Business start-ups
  2. Expansion
  3. Cash flow management

Comparing different types of loans is not usually a case of one method of financing being better than the others. It's more a case of matching the right type of loan with the needs and circumstances of the business.

In order to make that decision, it helps to understand the different options available to you. This business financing guide can be your reference for looking up which type of loan to consider for which situation.

Where to Find Business Loans

Besides the fact that there are different types of business loans, there are also different sources of financing. Knowing the full range of options can help you find a better deal.

Business financing can be found at:

  • Traditional banks
  • Online banks
  • Non-bank lenders
  • Credit card companies

Considering each of these sources can help you get the best credit terms for your business.

Using credit is part of a broader corporate finance picture which includes handling your company's cash and investments. Before starting any financial relationship on the part of your business, consider whether the financial institution you are dealing with might be able to help you obtain credit in the future.

Having a bigger-picture relationship with a lender can help you get better terms and easier approval the next time your company needs financing.

BUSINESS-LOAN-GUIDE

Best Business Loans for Start-Ups

What's the toughest part of running a business? Just getting started might be the most challenging, make-or-break situation you ever face.

After all, when you start a business the expenses typically come well before the revenues. This means you need more than just enough capital to open the doors. Your start-up financing may have to fund the business for several months while you wait for revenues to reach a critical mass.

This is a common reason start-ups fail: they are well-financed enough to launch, but not enough to survive the lean times until the business reaches profitability.

Making sure that doesn't happen can be a matter of finding financing that is of the right size and form for your needs. The following are some types of business financing that can help your company make it through the start-up phase:

Personal loans

When it comes to getting financing, businesses are like people - they generally have to build a credit history and earn a decent income before they can obtain funding.

Since a start-up does not yet have a credit history or revenues, the best option for funding the new venture might be for the founder to get a personal loan.

One difference between a business loan and a personal loan is who is on the hook for repaying the loan. If you use a personal loan to fund your company, you are personally responsible for repaying it. This is one of the risks of starting a business.

Unless you have collateral to secure a loan, your personal loan will be unsecured. This is generally the case with personal loans. Getting an unsecured loan requires having a good credit history and a reliable income.

It can also help if you work with a local lender. Banks and credit unions can be more open to working with a borrower in the same community because they are familiar with conditions in the area. They may also feel it's in their best interest to nurture new business creation.

If you do have collateral to put up against your loan, it could help your chances of getting financed. The downside is that you may forfeit your collateral if you don't repay the loan.

To increase your chances of getting a personal loan to start your company, check your credit report before you apply. Clearing up any mistakes or outstanding problems could raise your credit score.

In turn, knowing that score can help you shop more effectively for credit terms. Lenders tend to highlight their best rates when they advertise, but if your credit is less than perfect you will probably get less favorable terms. It's important to identify which loan terms are likely to apply to your situation so you can lenders.

Using a personal loan may be necessary to get your business off the ground, but it's probably not the best option for a company's ongoing financing needs. Work on establishing a good credit history for your company so that you won't have to be personally liable for future financing.

Summary:

  • A personal loan is a good fit for a start-up founded by someone with a strong credit history
  • The terms of a personal loan may not be cost-effective for a start-up founded by someone with weak credit

Rollover for Business Startups (ROBS)

If you have built up money in a 401(k), IRA or other type of self-directed retirement plan, you can borrow against it to start a business. This type of loan is called a Rollover for Business Startups (ROBS) loan.

The way this works is that when you form your new company you set up a 401(k) plan for that company. Then you roll your existing retirement plan balance into the new plan. You can then borrow against that balance, using the money to fund your new business. This has to be formally documented as a loan with repayment terms so you do not incur tax consequences.

If you currently participate in an employer-sponsored retirement plan, you will probably have to leave that employer in order to roll the money out of that plan. However, it would be wise to have your new company and its 401(k) plan set up before you leave your current job so you can make a direct rollover.

To be able to use your retirement plan balance for a ROBS loan your new company has to be a C corporation. There will be administrative costs involved in setting up a new 401(k) plan and documenting the loan, so this strategy may not be worthwhile if you only have a small amount of retirement money to borrow against.

Before you pursue this strategy, you should be aware of two risks. First, borrowing against your retirement fund means the money you borrow won't be available for investment. Worse, you could lose that money if your new business fails.

The other risk is that if you are unable to repay the loan, it could be considered an early withdrawal from the retirement plan. Unless you are aged 59 1/2 or older, this would make the amount you couldn't repay subject to income taxes plus a 10% penalty.

Summary:

  • Best fit for would-be business owners who have a substantial balance in a retirement plan
  • Not as cost-effective for small loans due to administrative costs

Franchise loan

If you are thinking of opening a franchise business, you may be able to get financing from the franchising organization.

While a franchise loan is a business loan rather than a personal loan, your personal credit history will probably be the main basis for whether or not you get approved. Your business education and experience may also factor in to whether you qualify for a franchise and are eligible for financing.

Even though a franchise loan may be a convenient way to get business financing, you should still compare the terms you are offered with alternatives you could obtain elsewhere. After all, the parent company of the franchise has a profit motive in making loans, so their interests and yours may not be the same.

Summary:

  • Best fit for new owners of franchises whose parent companies offer financing to franchisees
  • Not an option for non-franchise businesses

Unsecured loan

Security or collateral is something of value that you pledge to guarantee that the lender will get repaid. Not all loans are secured, so you should understand the merits of both secured and unsecured loans.

With a secured loan, the collateral you put up helps protect the lender against default. Providing that protection should help you get more favorable loan terms. As a start-up, your company may not have sufficient assets to put up as collateral so you may have to secure the loan with your personal property.

Starting a business is risky under any circumstances, and putting your personal property on the line to secure a loan makes it even riskier. An unsecured loan may be a safer option, especially if you have strong enough credit to qualify for a loan with reasonable terms.

Summary:

  • Best fit for new business owners with strong credit histories
  • Not an option if your credit record is too shaky to qualify for a loan without collateral.

BUSINESS-LOAN

SBA 7(a) loan

One way you might get a loan for your new venture is through the Small Business Administration (SBA). This is a federal agency that guarantees business loans. Having that federal backing can help you qualify for a loan even if you have a limited credit history.

To qualify for an SBA loan, you have to be actively involved in running a for-profit business within the United States. In order to be eligible you must demonstrate that you have already tried to get financing from other sources. So, you should pursue other loans first and view an SBA loan as a fallback option if you fail to get financing elsewhere.

Loans backed by the SBA can be anywhere from a few hundred to millions of dollars in value. The SBA has a range of programs, of which the 7(a) loan program is the primary way they provide financing. Loans can be for amounts up to $5 million but the amount the SBA guarantees varies depending on the size of the loan. The strongest guarantee covers 85 percent of the first $150,000 of a loan, so it might be easiest to qualify and get good terms on loans of that amount or less.

Summary:

  • Best fit for companies operating in the United States that otherwise might not qualify for a loan
  • Not available for operations outside the United States or those where the owner is not actively involved and invested in the company

SBA 504/CDC loan

Another SBA program is for companies that want to invest in commercial real estate. This is called the 504/CDC loan program.

You may be eligible for this program if you are borrowing to buy a building for your company's operations. Your company has to occupy most of that building in order for you to qualify for a 504/CDC loan, though you are also allowed to rent out a minority portion of the building to other businesses.

The way this program works is that the SBA matches private lenders with Certified Development Companies (CDCs). A CDC is a not-for-profit organization that lends money to promote the local economy. That mission of investing in local businesses can make it possible for startups to get financing.

Summary:

  • Best fit for companies that want to own their own facilities
  • Not an option for purposes other than investing in commercial property for use by the business

SBA microloan

Microloans are designed to encourage lending to very small businesses. The SBA has a microloan program that works in conjunction with non-profit lenders to make loans of up to $50,000. The SBA does not guarantee these microloans, but it does lend money to non-profit lenders to provide them with the capital to make loans.

In addition to providing a source of financing to businesses that might otherwise have trouble finding it, a microloan program might also provide training and business advice through the non-profit organization making the loan.

Summary:

  • Best fit for very small companies served by non-profit lenders whose mission is to help local businesses
  • Not available for loans of over $50,000

Not-for-profit business loan programs

Non-profit lenders don't just operate through the SBA microloan programs. Depending on where you are setting up shop, you may find there are city, state or philanthropic organizations that make economic development loans.

Getting one of these loans may involve more paperwork than an ordinary business loan. Organizations that are lending to promote the local economy will want to learn about the potential impact your business might have on the community. However, if a not-for-profit business loan proves to be your only way of getting financing, the extra paperwork may be well worth the effort.

Summary:

  • Best fit for small businesses in areas that receive government or charitable aid to promote the local economy
  • Not as likely an option for larger startups requiring extensive financing

>> Related: Personal Loan Myths You Should Stop Believing

Best Business Loans for Expansion

Once your business has been operating for a while, you may decide that it's successful enough to invest in expanding. The cost of this expansion may be too high to pay for with the day-to-day revenues of the company, so you will need financing.

The type of business loan you get in this situation should be suited for the type of investment you plan to make in plant, equipment or other resources.

Commercial mortgage loan

Leasing your place of business can make it easier to get started, but in time you may decide it makes more sense to own space for the company. This is especially true if the business has specialized needs or needs a lot of space to expand.

A commercial mortgage is a good option in this situation. This is similar to a home mortgage in that the property is used as collateral for the loan. This security should make a commercial mortgage loan easier to get and less expensive than other forms of business financing.

Since the property is being used to secure the loan, the lender will need to make an appraisal of its value. If that appraised value is less than the price you are paying for the property, you may only be able to borrow up to the appraised amount.

A commercial mortgage lender is likely to base loan decisions on the credit history and cash flow of the business. Because of this, your business may have to have been up and running long enough to have established a decent financial track record in order to qualify for a commercial mortgage.

Summary:

  • Best fit for businesses that have established a history of profitability and want to invest in real estate for the company's operations
  • Not an option for non-real estate purposes or for companies with limited history or poor profitability

Equipment loan

Whether its computers, machinery or vehicles, business equipment can be very expensive. The good news is that the value of this equipment can be used to secure a loan.

Using the equipment you are buying to secure the loan can ease the approval process and help you get better loan terms. However, you need to look beyond the approval process to make financial projections of the impact the loan payments will have on your profitability. Also, the repayment period for an equipment loan should be shorter than the lifespan of that equipment. Otherwise you will still be paying for equipment that is no longer in use.

You might find that the vendor of the equipment you want to buy can help arrange financing. This may be convenient, but don't limit yourself to considering only the vendor's financing. You might find you could get better terms from a lender that is independent of the vendor.

Summary:

  • Best fit for long-term equipment investments by established, profitable businesses
  • Not an option for financing that doesn't involve the acquisition of a business asset with tangible value

Installment loan

Besides the different purposes of business loans, there can also be different structures to those loans. These structures help you fit the repayment pattern to the needs of your business.

A common form of loan structure is an installment loan. This involves regular, uniform payments over a set repayment period. The process of spreading those payments over the repayment period is known as amortization.

The way amortization works out is that a greater portion of the initial payments will represent interest rather than principal. Then, as you pay down the loan over time you will be charged less interest since you won't owe as much. This allows more of the later payments to go towards paying down principal rather than towards interest payments.

One appeal of an installment loan is that the payments are of the same amount and at regular intervals. This helps make your cash flow more predictable. However, if you are investing in an expansion that might take some time to pay off you may find those regular payments difficult to make at first. Only later when the expansion starts to bear fruit will those payments become more manageable.

Summary:

  • Best for companies with strong enough cash flow to make regular loan payments
  • Not as attractive for companies that need to minimize near-term costs

Balloon loan

Unlike an installment loan that has the same payment amounts throughout the life of the loan, a balloon loan starts out with smaller payments and then makes up for it with a large payment towards the end of the loan. This big payment on the back end of the loan is known as a balloon payment.

Because this type of loan pays back principal more slowly at first, more interest will be charged on that principal. It also requires careful planning to make sure the business will have the cash available when the balloon payment becomes due.

On the plus side, this type of loan can work well for expansion projects because it minimizes early payments and thus gives the expansion time to start generating profits.

  • Best fit for long-range expansion plans to boost revenue
  • Not as cost-effective for companies with strong enough cash flow to afford installment payments

Hard money loan

Hard money loans are made by private investors who use company assets to secure their loans. These investors protect themselves by limiting the amount of their loans to between 50 and 70 percent of the value of the collateral used to secure the loans. These loans also generally have relatively short repayment periods.

While the collateral requirement restricts the value of these loans, hard money loans may be useful for expansion projects because approval is based more on that collateral than the cash flow of the business. This can help a business get a loan while it is still working on improving its cash flow.

Summary:

  • Best fit for companies wanting to get financing more quickly than they could through traditional lenders
  • Not an option unless the company has substantial collateral to secure the loan with and the means to pay off the loan within a relatively short time

Best Business Loans for Managing Cash Flow

Starting or expanding a company may require financing to allow you to invest in the business, but many companies also need financing on more of a routine basis to help them manage cash flow. The timing of revenues often does not match the timing of expenses, and financing can be used to make capital more readily available when you need it.

Business credit card

A business credit card is a day-to-day source of financing. It allows a company to access credit on demand without having to apply for a loan every time.

The benefits of a business credit card include immediacy and convenience, but those benefits come at a cost. Interest rates on credit cards are generally more expensive than loan rates. However, this cost can be minimized if you make it a practice for the company to pay off the credit card balance in full each month.

Just like with a personal credit card, getting approved for a business credit card depends on the company having a good credit history and reliable income. Therefore, it may take time for a business to establish itself before it can get a corporate credit card.

Summary:

  • Best fit for companies with a good credit record
  • Not as attractive for companies with less credit history or poor cash flow

Line of credit

A line of credit gives you an approved amount of credit available from a lender whenever you need it within a specified period of time.

This gives you the certainty of having arranged credit terms in advance combined with the flexibility to use that credit only when you need it. As a result you only pay interest on the amount of credit you use.

One thing to watch out for is that there might be costs involved in setting up the line of credit. So, you shouldn't start one unless you are sure you are going to use it.

Sometimes a company is actively looking to make investments but the timing of those investments is uncertain. A line of credit can be a good solution for making sure the necessary financing will be available when the time comes.

Summary:

  • Best fit for established companies pursuing investments whose timing is unknown
  • Not as attractive for companies that aren't sure they will need financing

Letter of credit

A letter of credit is a guarantee from a bank to provide payment on behalf of a business once the terms of a deal have been satisfied. This mode of financing is commonly used for companies making purchases from non-US vendors with whom they have not yet established a relationship.

Essentially, when buyers and sellers of goods don't know each other and are dealing internationally, the bank's role in providing a letter of credit is to act as a third party the buyer and seller can both trust. This can facilitate transactions and over time help a company establish relationships with foreign vendors.

A bank is only likely to provide a letter of credit on behalf of a trusted customer, which may entail having a well-established relationship with the bank. It may help to have a substantial amount of money on deposit with that bank.

Summary:

  • Best fit for businesses with established banking relationship looking to forge new international supplier relationships
  • Not as attractive for newer companies or those not interested in doing business internationally

Short-term loan

Short-term loans, bridge loans and interim loans are all similar forms of the same type of credit. They provide cash quickly, which can help to initiate a deal until longer-term financing can be arranged.

While these loans deliver quick approval, they typically carry very short repayment terms and higher expenses. Pay particular attention to fees and closing costs. On a shorter-term loan, those expenses are effectively amortized over a shorter period of time and thus represent a higher percentage cost.

Short-term loans play a role somewhere between a business credit card and more conventional business loans. They may allow for somewhat larger amounts and longer repayment terms than you would generally use a credit card for, but they are more immediate than most loans. With the downside being the cost, the idea is to use these only to fill occasional gaps in financing rather than as credit to be routinely rolled over to fund the day-to-day operations of the business.

Summary:

  • Best fit for companies needing temporary financing before more cost-effective options become available
  • Not as attractive for companies with longer-term or ongoing financing needs

Factoring

Factoring is not a loan, but it is a form of business financing that can help you manage cash flows.

The way factoring works is that you sell customer receivables to a factoring company at a discount from their value. This provides your company with cash up front, while the factoring company then has the right to collect the receivables from your customers at full value.

When you sell your receivables up front, a factoring company is likely to pay only 80 to 95 percent of their value, depending on how likely those receivables are to be paid. This discount means that you are giving up some of the financial value of your billings in exchange for having access to the money sooner.

Summary:

  • Good for companies with business that generates a high volume of receivables
  • Not as attractive if your business generates sufficient reserves to pay for immediate needs rather than needing to sell receivables at a discount in order to do so.

Purchase order financing

Manufacturing companies or any business that incurs significant costs for raw materials may experience delays between having to pay for those materials and when the finished product is sold to customers. This kind of delay may require financing to fill the gap.

Purchase order financing can be a good solution for this type of situation. The lender will loan you money using the pending purchase orders of your customers as security. The ability to get this kind of financing and the terms a lender offers will depend on how creditworthy your business and your customers are.

This technique can smooth out irregular cash flows. Businesses selling expensive goods may find their receipts come in at irregular intervals. That can make it difficult to meet immediate needs in between those receipts without financing.

Ideally, a company will build sufficient reserves in time to get by without regular financing costs. In the meantime though, purchase order financing can be a useful stopgap solution.

Summary:

  • Best fit for companies with long delivery lead-time and the need to invest in materials or other resources up front
  • Not as attractive as an ongoing procedure because it increases operating costs

Merchant cash advance

A merchant cash advance is similar to factoring in that it entails selling rights to your future receipts in exchange for immediate cash.

The difference is that unlike factoring, you don't sell specific receivables to get a merchant cash advance. Instead, these advances are based on the general flow of credit receipts. Because a merchant cash advance is not based on a single, large receivable, it is better suited to companies that do a high volume of relatively small sales.

Like factoring and purchase order financing, merchant cash advances can help a growing company manage cash flows. It provides fresh capital sooner so you can continue to grow the business. However, they may not be the most desirable long-term strategy because they add to your business expenses.

Summary:

  • Best fit for high-turnover, credit-based businesses with continuous cash needs
  • Not as attractive as a permanent approach because of the added costs

Always Compare Business Loan Options

The one constant in the loan market is change. Interest rates are always changing. Loan approval methods and standards may become tighter or looser depending on how the economy is doing. Lenders come up with new financing structures from time to time that may be worth considering.

This continual change means that a business must always be alert for better financing methods and terms. Always take time to shop around. While setting up a routine for accessing business credit can be convenient, never forget that each time you seek financing there's a chance to improve your profitability by finding a better way.

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