Business owners discussing small business loan application with funding advisor
Essential Guide to Small Business Funding Small Business Funding

How Do Small Business Loans Work?

“How do small business loans work?” may seem like a simple question with an equally simple answer, but if you’ve ever considered applying for small business funding, you know that small business loans are far from straightforward. Each type of small business loan works differently and the requirements vary greatly by lender. Understanding how they all work and which loan type or lender is a good fit for your business can be exhausting.

Don’t be discouraged! The specifics may differ significantly, but there are commonalities between loan and lender types. To help you understand the essential components of small business funding, this guide will provide some general advice and information about how small business loans work, including:

  • The basics principles of how small business funding works
  • Different types of lenders
  • Summary of different types of small business loans
  • Repayment options

Let’s get started.

The basic principles of small business funding

Here’s some good news: You’re probably already familiar with the basic principles of how small business funding works. Here’s a quick overview:

  1. Business loans are offered by lenders. There are multiple types of lenders, including traditional lenders like banks and credit unions, as well as SBA-backed loans and alternative online lenders like Greenbox Capital®. Different lenders have different application requirements—read more about that in our guide to small business loan requirements.
  2. If your application is approved, the lender will supply the funding you need, plus interest or a factor rate, as well as other fees. The terms of your funding will depend on the specific type of funding you receive.
  3. You pay back the funding over a set amount of time, with regular payments determined in advance by you and your lender.

The exact structure of your loan, including repayment terms and fees, depends on the type of loan you receive, as well as the type of lender you’re working with.

We’ll explore each of these basic principles in detail throughout this guide.

Types of lenders

1. Traditional lenders

Traditional lenders such as banks and credit unions offer a variety of lending options, including:

  • Term loans
  • Lines of credit
  • Real estate loans
  • Equipment financing

These lenders tend to approve only well-established businesses with strong financial histories seeking loans for larger amounts. The application process is lengthy and intrusive, and most applicants are rejected, especially for newer businesses or smaller loan amounts that will generate less profit for the lender.

2. Small Business Association (SBA) or Business Development Bank of Canada (BDC)

SBA- or BDC-backed loans are supplied by intermediary lenders, but are guaranteed up to 80% by the SBA (or BDC in Canada). This reduces the risk to the lender and encourages them to grant more loans.

These loans typically carry the best terms with lower fees, but the application process is very difficult and lengthy, and the vast majority of applicants are rejected.

3. Alternative lenders

Also referred to as online lenders or direct lenders, alternative lenders offer funding supported by new technology and online platforms that streamline the application and underwriting process. These lenders offer a variety of funding options, often for shorter terms and smaller amounts. Rates are typically higher, but application requirements are also easier and more flexible with faster approval.

Alternative lenders are an ideal choice for businesses who are unable to acquire funding from traditional lenders, such as newer businesses, businesses with lower credit, or businesses who need working capital quickly. However, not all alternative lenders are created equal—make sure you thoroughly screen your funding partner, and only work with lenders who provide responsible funding.

Types of small business loans

There are many different types of small business loans available to business owners, each with their own qualification requirements, rates, and terms.

The type of funding that works best for your business will depend on a number of factors, including your intended purpose, your business’s history and earning potential, and the type of lender you apply for funding from.

Here’s a summary of 10 of the most common types of small business loans:

Term Loans

DescriptionLump sum repaid at regularly scheduled intervals over length of term, plus interest.
Typical Term Length1-5 years
Cost of CapitalLower than other funding options
Approval DifficultyHigher than other funding options, with in-depth applications and long wait times
Common Uses
  • Buying real estate
  • Purchasing another business
  • Renovating or remodelling
  • Planning long-term expansion
Other ConsiderationsMay carry early repayment charges

Short Term Loans

DescriptionSimilar to a term loan, but with a shorter term length
Typical Term LengthVaries by lender
Cost of CapitalHigher than other funding options
Approval DifficultyEasier application process with less paperwork and faster approvals
Common Uses
  • Short-term funding needs
  • Immediate or emergency funding needs
Other ConsiderationsIdeal for applicants with low credit

SBA Loans

DescriptionLow cost loans offered by intermediaries and guaranteed by the SBC (or BDC in Canada)
Typical Term LengthLonger terms
Cost of CapitalLower rates than other funding options
Approval DifficultyVery difficult, sometimes taking months
Common Uses
  • Purchasing or upgrading real estate
  • Purchasing machinery, equipment, inventory, or supplies
Other ConsiderationsMultiple types of SBA loan are available depending on your needs

Merchant Cash Advance

DescriptionA “non-loan” form of financing in which a lender provides working capital up front in exchange for a portion of your future credit and debit sales.
Typical Term LengthShorter terms, typically less than 1 year
Cost of CapitalHigher than other forms of loan
Approval DifficultyStreamlined application process with greater chance of approval
Common UsesFunds can be used however business owners choose
Other ConsiderationsFees are charged based on a factor rate rather than traditional interest/APR rates

Invoice Financing

DescriptionLeverage unpaid invoices to gain access to working capital.
Typical Term Length60-90 days
Cost of CapitalVaries by lender and invoice amount
Approval DifficultyEasier than other loans because financing is secured by invoice
Common Uses
  • Cover operating expenses
  • Fill in cash flow gaps
Other ConsiderationsMany types of invoice financing are available

Business Line of Credit

DescriptionProvide a maximum credit amount from which funds can be drawn and repaid as needed.
Typical Term LengthVaries by lender and applicant
Cost of CapitalVaries by lender and applicant, typically lower than other forms of funding
Approval DifficultyVaries by applicant
Common Uses
  • Cover operating expenses
  • Purchase inventory
  • Fill seasonal gaps in cash flow
  • Cover unexpected emergency costs
Other Considerations
  • Can be fixed or revolving
  • Can be secured or unsecured

Equipment Financing

DescriptionFinancing specifically designed to purchase new equipment
Typical Term LengthVaries by lender
Cost of CapitalVaries by lender and applicant
Approval DifficultyEasier than other loans because financing is secured by equipment
Common UsesPurchasing new equipment
Other ConsiderationsCan only be used to purchase new equipment

Commercial Real Estate Loan

DescriptionFor the express purpose of purchasing or improving commercial real estate.
Typical Term Length20-30 years
Cost of CapitalVaries by lender and LTV
Approval DifficultyHigh
Common UsesPurchase or improve commercial real estate
Other ConsiderationsProperty acts as collateral to secure the loan.

Microloan

DescriptionSmall loans under $1,500 offered by non-profit organizations
Typical Term LengthVaries by lender and applicant
Cost of CapitalVaries by lender and applicant
Approval DifficultyModerately difficult
Common Uses
  • Covering start up costs and operating expenses
  • Purchasing inventory or equipment
  • Boosting marketing and promotions
Other ConsiderationsIdeal for underserved entrepreneur communities

Personal Loan for Business Use

DescriptionLoans based on your personal financial profile, not your business
Typical Term LengthVaries by lender and applicant
Cost of CapitalVaries by lender and applicant
Approval DifficultyEasier than other forms of business funding, especially if you have good personal credit
Common Uses
  • Purchasing real estate or equipment
  • Remodelling or renovating
  • Boosting marketing and promotions
  • Stocking up on inventory and supplies
  • Continuing education and training
Other ConsiderationsBusiness loans are always recommended for businesses who can qualify

For detailed information about the different types of small business loans, including rates and terms, application information, and who should apply, check out our guide to 10 Common Types of Small Business Loans.

Repayment options

Your repayment terms will depend on the type of loan you receive. There are three primary repayment structures for paying back your small business funding:

1. Revolving

With revolving funds, you are granted a credit line that you can access and repay as needed. As long as the account is open, you can draw and repay up to your maximum credit limit multiple times. The most common example of revolving funding is a business credit card or some business lines of credit.

2. Installment

With installment funding, you’ll receive the full amount of your loan up front and will pay it back in equal installments according to a schedule you set up with your lender, typically with fixed monthly payments. The most common example of installment funding is a traditional term loan.

3. Cash flow

You’ll receive the full amount of your loan up front, but repayment will be based on your cash flow rather than a set payment or term length. When repaying a merchant cash advance, for example, your lender will automatically deduct a percentage of your daily or weekly credit and debit sales until the advance is repaid. The most common examples of cash flow funding are merchant cash advances or invoice factoring.

Wrapping Up

There is no easy answer to the question “how do small business loans work?”. Each type of loan works differently, with varying requirements, qualification criteria, and terms. Lenders work differently as well, adding up to one complicated lending landscape that can discourage even the most entrepreneurial small business owner.

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