A Guide to Small Business Borrowing

Many small businesses rely on borrowed capital to fuel growth and other initiatives. Depending upon the nature of the business need, a business’ credit profile, time in business, whether or not the business has adequate collateral, and other factors, there are more options available today than ever before. Nevertheless, with all these options, small business borrowing has become more complicated.

The local bank has been small business’ traditional source for borrowed capital—and still remains a viable option for those businesses that can meet their potentially strict criteria. Nevertheless, there are additional choices, which could make sense for your business, once you understand the landscape of potential loan options. Some of these options could be a good fit for very young companies and others help solve some of the challenges faced by almost every small business.

A Term Loan at the Bank

A term loan at the bank is what most people think of when they think of small business borrowing—which is why it makes sense for this to be at the top of the list. What’s more, many of the other loan types share similar characteristics with a traditional term loan, so it makes sense to understand how a traditional term loan works.

Although it might not always be the best place for every small business to look first, it makes sense that many businesses start at the bank when they need to borrow capital. They likely have other business banking accounts there, they have a relationship with the bank, and they may even have a personal relationship with the banker.

If you’ve ever had a car loan or a home mortgage, you’re likely familiar with the basics of how a term loan works—a small business loan may share many of the same characteristics. The word “term” refers to the period of time during which you make the periodic payments (30 years is a common term for a home mortgage, for example). Like a home mortgage, every term loan has a specified repayment period. A typical term loan at the bank for a business loan could be four, five, 10 years, or longer. The term is usually dictated by the loan purpose.

A traditional term loan is often used to purchase assets like real estate and equipment, but may also be used to expand a restaurant, build a commercial building, or to fill other business needs. There are many business capital needs that could be a good fit for a term loan.

The exact repayment term may be matched to the useful life of the asset being purchased. For example, the term for purchasing computer equipment or a copy machine will likely be very different from the term frequently associated with purchasing a commercial building, real estate, or heavy equipment.

How Term Loan Payments Work

Loan payments typically include a combination of interest and a portion of the principle balance in every loan payment. The amount of interest and principle in the loan payment will vary, and is identified in an amortization schedule determined by the bank. Typically more interest is paid in the beginning of the loan term, and more principle is paid as the loan approaches the end of its term.

The fees associated with term loans can either be paid up front or added into the loan balance (depending upon your lender). Annual Percentage Rate (APR) is a reflection of the interest cost and fees charged expressed in an annual percentage rate. Auto loans, mortgages, credit cards, and other consumer debt is expressed in APR to make comparison shopping for consumers easier. Small business term loans from the bank may also be expressed in APR—making it one of several ways to compare small business loans. When comparing business loans with vastly different terms, however, using APR alone may not tell the full story.  Instead, it should be considered along with the total loan cost, which will typically be lower on a shorter-term loan and help determine whether a loan is the right fit for a given business need.

Collateral

Many banks will require some form of specific collateral to secure a loan. Collateral is an asset of value the lender will take ownership of should a borrower default on a debt. If the loan is intended to purchase some kind of asset, like a piece of equipment or real estate, the lender might use the asset being purchased as collateral. An easy-to-understand example from the consumer lending world is an auto loan. The car being purchased serves as collateral to the lender until the balance is paid in full, which is why the auto lender holds the title to the vehicle until the entire balance is paid—giving them the option of repossession should the borrower fail to make his or her auto payments.

Many banks will also require a borrower to insure an asset being purchased over the course of a loan (with an insurance policy acquired for that purpose), to protect the value of the asset being purchased with the loan proceeds. This may apply to a business loan for purchasing equipment or other similar asset. If the borrower fails to purchase adequate insurance, the bank may add those costs to the balance of the loan.

Bank Term Loan Rates and Fees

At the bank, the interest rate you’ll be charged will depend upon a variety of factors, including:

• The current index rate (usually the Prime Rate, LIBOR, or the Treasury Rate—based upon the type of loan)
• The perceived credit risk represented by your loan (your personal and business creditworthiness)
• The length of the loan term

Interest rates on a term loan can be either fixed or variable. A fixed rate will not change throughout the term of the loan, regardless of what happens within the capital markets. With that in mind, a good time to get a fixed-rate loan would be when interest rates are low.

A variable interest rate will be based upon an interest rate index (see above), which will be associated with the bank’s cost of capital. When you agree to a variable interest rate, you are agreeing to a rate based upon the index, plus a defined interest margin. In other words, as the lender’s cost of capital fluctuates, you interest rate can also go up or down within the term of the loan.

Why Would a Term Loan Make Sense for a Small Business?

With all the options available for business borrowing today, a term loan could be a good fit for those businesses that meet the banks’ criteria because a term loan at the bank will often include the lowest interest rates. A traditional term loan could be a good fit for specific, high-cost purchases that will provide value to your business over a long period of time:

• Equipment, machinery, and other tools for manufacturing, service, and repair businesses
• Technology and other office equipment, such as computer equipment, phone systems, copiers, furniture, and other similar technology
• Real estate, office space expansion, renovations, and new construction

How to Apply

Like any business loan, applying for a term loan from the bank will require submitting specific information about your business and the business owners. The information required may differ from bank to bank, and you should be prepared to respond with additional information once they’ve begun the review process. Some of the standard information/documentation the bank may want to see could include:

• A detailed business plan that outlines why you are looking for a loan, what, if any, assets will be purchased with the proceeds from the loan, and how you expect the business to benefit from using the borrowed funds in this way.
• Business financial statements for up to the past three years, including balance sheets and profit and loss statements (P&L).
• Tax returns for both the business and the owners for the past three years.
• A debt schedule.
• Personal financial statements of all the business owners.
• The lease for the business premises, if applicable.
• Financial projections for three years showing what you expect revenue and expenses to be. You should also plan on demonstrating how those operations will make it possible to repay the proposed loan.
• Resumes for all business owners and key employees.
• Information about the assets to be purchased, including a copy of the sales contract or purchase agreement, if applicable.

The bank will review your business and personal credit profiles with the appropriate credit bureaus—so it makes sense for you to understand what is reported within your personal and business credit profiles as well (if you don’t know already).

The turnaround time for a typical bank term loan can take up to several weeks. You can streamline this process somewhat by ensuring you have the above-mentioned information ready and at your fingertips. You should also be committed to responding quickly for any additional information the bank may request.

An SBA Loan

The first thing you need to know about an SBA (U.S. Small Business Administration) loan is that the SBA is not a lender. Rather, the SBA provides a guarantee to participating banks and credit unions to encourage lending to small businesses.

How is an SBA Loan Different From a Traditional Term Loan at the Bank?

The SBA works through participating banks, credit unions and other licensed non-bank lenders. The SBA is a federal agency that promotes small business ownership in a variety of ways, including their loan guarantee program. The loan guarantee is in effect, credit insurance for the SBA lender. Meaning the SBA will cover a portion of any loan losses incurred by the bank—potentially up to 90 percent.

If the lenders adhere to specific lending terms, interest rate caps, and other criteria set out by the SBA, the agency will share the risk with the bank, making small business lending more attractive to the bank. They do this because small businesses account for two out of every three net new jobs and hire roughly half of the U.S. workforce. Because small businesses are considered higher risk than their larger cousins, the SBA loan guarantee helps banks offer more flexible loan terms, meaning borrowers can be approved even if they have fewer assets than what would be required with a traditional term loan at the bank.

Because the SBA doesn’t actually make small business loans, they don’t interact with borrowers. The bank, credit union, or other lender, you may be working with decides whether or not to approve loan applications. Then they apply directly to the SBA for the guarantee.

Not all banks participate in the SBA loan guarantee program, so if you’re looking for an SBA loan, you can start your search with SBA.gov to find the SBA lenders in your area.

There are Several Types of SBA Loans

Depending upon your loan purpose and the amount of money you’re looking for there isn’t a one-size-fits-all SBA loan. The most popular options include:

The 7(a) Loan

The most popular SBA loan program is the 7(a) program. This program was designed to fit a broad range of business needs. The maximum loan amount for a 7(a) loan is $5 million and the funds may be used for almost any business need, including:

• Starting a new business
• Funding working capital
• Buying land or a building
• Acquiring another company

Many 7(a) loans are used to purchase assets like real estate and equipment because the terms are favorable and allow you to repay the loan in terms compatible with the life of the asset being purchased. For example, 25 years for real estate and 10 years for equipment. The longer repayment terms enable lower payments and make sense for the loan purposes for which they are intended.

There are some restrictions regarding how the funds may be used. They may not be used to fund an investment or any passive business activity, like purchasing a building that will be leased to another business. They also may not be used to reimburse a business owner for money he or she has previously invested in the business or used to repay money owed to the government, such as a tax debt.

Is a 7(a) Loan a Good Fit to Meet Your Business Need?

If you are a small business as defined by the SBA criteria, operate for profit, do business in the United States, and any of the following criteria apply to your business, a 7(a) loan could be an option for your business if:

• You have reasonable invested equity
• You have used alternative financial resources, including personal assets, before seeking financial assistance
• You are able to demonstrate a need for the loan proceeds
• You will use the funds for a sound business purpose
• You are not delinquent on any existing debt obligations to the U.S. government

There are some ineligible businesses the SBA identifies as unacceptable for financial assistance from a federal provider, including the following:

• Financial businesses primarily engaged in the business of lending, such as banks, finance companies, payday lenders, some leasing companies and factors (pawn shops, although engaged in lending may qualify in some circumstances)
• Businesses owned by developers and landlords that do not actively occupy the assets acquired or improved with the loan proceeds (except when the property is leased to the business at zero profit for the property’s owners)
• Life insurance companies
• Businesses located in a foreign country (businesses in the U.S. owned by aliens may qualify)
• Businesses engaged in pyramid sales distribution plans, where a participant’s primary incentive is based on the sales made by an ever-increasing number of participants
• Businesses deriving more than one-third of gross annual revenue from legal gambling activities
• Businesses engaged in any illegal activity
• Private clubs and businesses that limit the number of memberships for reasons other than capacity
• Government-owned entities
• Businesses principally engaged in teaching, instructing, counseling, or indoctrinating religion or religious beliefs, whether in a religious or secular setting
• Consumer and marketing cooperatives (producer cooperatives are eligible)
• Loan packagers earning more than one third of their gross annual revenue from packaging SBA loans
• Businesses in which the lender or CDC, or any of its associates owns and equity interest
• Businesses that present live performances of an indecent sexual nature or derive directly or indirectly more than 2.5 percent of gross revenue through the sale of products or services, or the presentation of any depictions or displays, of an indecnt sexual nature
• Businesses primarily engaged in political or lobbying activities
• Speculative businesses (such as oil exploration)

In addition to the above conditions, the business cannot have been:

• A business that caused the government to have incurred a loss related to a prior business debt
• A business owned 20 percent or more by a person associated with a different business that caused the government to have incurred a loss related to a prior business debt
• A business owned 20 percent or more by a person who is incarcerated, on probation, on parole, or has been indicted for a felony or a crime of moral depravity

Applying for a 7(a) Loan

The application process will be similar to that required for a traditional term loan at the bank, and will likely include:

• A detailed business plan
• Business financial statements for the last three years, including balance sheets and profit and loss statements (P&L)
• Tax returns for the business and its owners for the past three years
• Detailed information on any other business loans the business may currently have
• Personal financial statements on all the owners who hold more than 20 percent of the business
• The lease for the business premises, if applicable
• Financial projections for three years showing what you expect revenue and expenses to be, and demonstrating that business operations will be able to repay the proposed loan

The bank will review your business and personal credit profiles with the appropriate credit bureaus—so it makes sense for you to understand what is reported within your personal and business credit profiles as well (if you don’t know already).

You may be required to provide additional information related to the specific loan purpose. For example, if you’re planning to use the loan proceeds to buy another business you will need to provide a copy of the purchase contract, the target company’s financial statements, tax returns, and other details about them.

The SBA Approval Process

There are really two loan approvals you’ll need for an SBA loan. The bank where you apply will review your application and decide whether you meet their qualifications, subject to SBA approval. (NOTE: The bank is required by the SBA to observe the “credit elsewhere” rule, meaning that if your company is qualified for a loan from another source without the credit insurance provided by the SBA, you should be sent there.)

Once the lender has agreed to the loan, they will seek the SBA’s approval for the guarantee. Processing a 7(a) application by the SBA can take several weeks. Some banks have delegated authority with the SBA, which will make the process much faster.

If approved, it could take between 30 to 60 days to close the loan and receive funds—which might not make this the best choice to fill a short-term need that requires a quicker response. The length of time required will be determined by the use of funds and the collateral required. If you’re using the loan to buy real estate or another business, your closing will coincide with the purchase closing.

7(a) Interest Rates, Terms, and Fees[1]

The maximum 7(a) loan amount is $5 million, and the average loan amount is somewhere between $350,000 and $450,000. There is really no minimum loan amount and the SBA has removed fees on loans under $150,000 to encourage more loans to smaller small businesses. The current SBA Administrator, Maria Contreras Sweet, has also worked to expand their relationships with credit unions to encourage more SBA loans in that sub $150,000 category.

With the exception of loans under $150,000, borrowers pay a one-time up-front fee, depending upon the size of the loan guarantee. Small loans, (those under $750,00 and more than $150,000) have lower fees. The SBA does not allow other fees to be assessed by the lender unless there are extreme circumstances, such as higher-than-normal servicing required by your loan.

Loan terms are negotiated with the lender that provides the loan, within a few parameters:

• Fixed and variable interest rates are available
• Lenders are limited to how much they can add to the prime rate based upon the size of the loan
• Maximum loan terms are determined by the use of loan funds; for example:
  • 25 years for real estate and improvements
  • 10 years for equipment
  • 7 years for working capital
• Personal guarantees are required for all owners with 20 percent or more ownership
• Monthly loan payments are required
• Borrowers will have to pay for all costs associated with the lender’s due diligence on collateral—this may include attorney’s fees, appraisals environmental assessments, etc.

The 7(a) loan program is the most popular SBA loan, and what most people think of when they think of an SBA loan. There are other SBA loan types, however, including what is outlined below.

The CDC/504 Loan Program

Business borrowing with a 504 loan works differently from a 7(a) loan. Most 504 loans are done through a non-profit organization called a Certified Development Company, hence the CDC designation. These companies work in tandem with the SBA and a participating lender, like a bank or credit union.

Qualification Criteria

The process is more involved than other SBA loan programs because there are multiple players working together to fund the loan. The maximum loan amount for a 504 loan is $5 million, but the actual loan amount will be determined by how the funds are used. 504 loans are tied to some kind of community development goal—creating jobs being the underlying objective. The metric for a 504 loan is to create or retain one job for every $65,000 provided by the SBA loan program. Small manufacturers have a different goal of creating or retaining one job for every $100,000. So qualifying for a 504 loan will need to include a job creation objective.

To qualify, applicants must have a net worth of less than $15 million and an average net income of less than $5 million after taxes. Many of the same restrictions described above for the 7(a) loan program also apply to a 504 loan.

504 Interest Rates and Terms[2]

504 loans can have either a 10-year term (for equipment) or a 20-year term (for real estate), giving borrowers the ability to repay the loan over the lifetime of the asset. Interest rates are pegged to an increment above the current market rate for 5-year and 10-year U.S. Treasury issues. A 504 loan may include a fee of approximately three percent, which may be financed with the loan.

SBA Micro-Loans

The SBA defines a micro-loan as a loan of $50,000 or less. The average SBA micro-loan is $13,000.

These loans are an option for businesses looking for smaller amounts of money to start or expand—but don’t need the larger loan amounts typically associated with a 7(a) loan. A micro-loan cannot be used to pay debts or purchase real estate.

Unlike 7(a) and 504 loans, which are only offered to for-profit businesses, micro-loans are also available to not-for-profit businesses like childcare centers—although there are ineligible non-profit businesses that are excluded.

Additionally, micro-loans come directly from government funds, which are administered by local non-profit lenders in the communities they serve. Micro-loans are administered by the community lending institutions, so unlike the standardized terms and requirements of a 7(a) loan, eligibility requirements, terms, and interest rates are determined at the local level.

You should also know:

• You may be required to participate in business training conducted by the community lender that administers the funding
• The term of the loan will likely be much shorter, with a maximum repayment period of six years

Click HERE for a state-by-state listing of non-profits that administer micro-loans for the SBA.

It’s Not Your Grandfather’s SBA Anymore

The SBA was founded in 1953 by President Eisenhower to promote the growth of small businesses in the United States, but in recent years, they have stepped up their game. Although the loan guarantee program is only one of many things the SBA does to help small businesses, because they recognize that access to capital is a big challenge for many of the businesses they serve, they’ve made some recent changes that portend a positive impact for small businesses.

• They have removed fees on 7(a) loans under $150,000 to encourage their participating banks to make more loans within that category
• They introduced the LINC tool, which gives borrowers greater visibility into which banks are making SBA loans and which might be a good place for a business owner to apply for a loan. The goal is to reduce the time it takes for a business to find an SBA lender, since all banks don’t participate in the program.
• The SBA has been consolidating the paperwork required for an SBA loan. Technology platforms like SmartBiz, are putting the applications online and otherwise making it easier for banks to make SBA loans—and thus encouraging them to do more of them.
• They have been encouraging more credit unions to become SBA lenders. The result has been a 25 percent increase in business lending through credit unions in 2013-2015.

Online Small Business Lenders

Many online lenders share characteristics with traditional lenders and their small business loans, in many ways, are similar to traditional term loans. Nevertheless, as traditional lenders have shied away from the smallest small businesses; and loans to those businesses has been in overall decline since the year 2000[3], online lenders are using technology to look at other information available from the public record as well as transaction history, cash flow, and other metrics in addition to credit profiles, that demonstrate a healthy business.

What’s more, these lenders aren’t relying exclusively on technology to streamline the process, but have created a new paradigm for evaluating business creditworthiness that is allowing more small business owners to access more capital than ever before.

Short-Term and Long-Term Loans

One way online lenders are addressing business borrower’s divergent needs is by reconsidering loan terms. In other words, the financing requirements for purchasing quick-turnaround inventory or bridging a seasonal cash flow gap are very different from financing the construction of a new building, expanding into a new location, or purchasing heavy equipment.

By better suiting the loan term with the loan purpose, businesses can control their cash flow and better leverage the borrowed capital to fuel business growth. According to a survey of 592 Main Street small business organizations conducted by Edelman Intelligence on behalf of the Electronic Transactions Association (ETA) in early 2016, businesses anticipate a 5x return for every dollar they borrow.67 percent of those same businesses believe they have more options available to them today and 94 percent of them perceive that having more options helps them do that.

Some online lenders tend to specialize in either long-term loans or short-term loans—but there are also those that do both, so depending upon your business need, you’ll likely need to verify whether any potential online lender offers the loan terms you need to meet your business need.

The Application Process

Another area where business borrowing from online lenders has had an impact in small business lending is how frictionless they’ve made the application process. Applications are usually a simple form that takes only a few minutes to complete, can be completed online, and the business will know in less than an hour—sometimes even a few minutes—whether their application has been approved or declined.

The document requirements to start an online loan application may vary from lender to lender, but are typically much less than a traditional bank term loan or an SBA loan. They may include:

• Your Social Security Number
• Your Business Tax ID Number
• Several months of business bank statements
• Financial statements

Collateral

Unlike a traditional term loan, most online lenders don’t require specific collateral, which makes it possible for many businesses that lack that collateral to get a loan. Rather, they may apply a general lien to business assets during the loan term and require a personal guarantee (a personal guarantee is also a common practice used by most banks).

Online Loan Interest Rates and Fees

Interest rates and fees vary from lender to lender, and comparing vastly different loan terms with the same metric can be challenging, so it’s important to ask any potential lender for some of the following information:

• The total interest cost (or total cost of the loan)
• The fees associated with the loan
• APR (which includes an annualized interest cost plus any fees)

Understanding this will make it easier to compare loans of different terms and allow you to determine which loan type best fits your business need. For example, 57 percent of those surveyed by the ETA chose a shorter-term loan with a higher APR for a short-term loan purpose because it offered a lower overall dollar cost when compared to a longer-term loan with a lower APR.

Because auto loans and mortgages are presented in APR (Annual Percentage Rate), it’s easy to assume it makes sense to solely compare all business loans that way. Although APR might be one way to compare loans, it may not provide all necessary information, especially when comparing loans with vastly different terms.

Along with asking about the APR and fees, it’s also important to know what the total interest cost—or total dollar cost of the loan will be. For example, if you were to borrow $10,000 and your total payback was $11,500, your total cost would be $1,500. It might sound counterintuitive, but there are situations where the total dollar cost of the loan might best help you fit the loan to a particular business need or use-case.

Your loan purpose will help inform this decision.

The advent of daily or weekly periodic payments is a departure from a more traditional monthly payment approach. Nevertheless, many lenders (including online lenders) have adopted a more-frequent-than-monthly payment schedule for a number of reasons. Not the least of which is that it tends to smooth out the cash flow burden throughout the month rather than the traditional lumpy cash flow drain associated with a single payment every month.

If your potential lender requires a daily or weekly payment schedule, though, it’s important to make sure your business has consistent cash flow throughout the month. This type of payment schedule might not be a good choice for businesses that rely on a month-end influx of cash flow to maintain business operations or on infrequent inward deposits.

Why Would an Online Loan Make Sense for Your Business?

There are several situations where an online loan could make sense to fill your business need:

1. Your business doesn’t meet the rigid credit criteria at the bank: Because many online lenders focus primarily on the health of the small business, instead of largely being driven by the owner’s personal credit score, they will often accept a broader range of business applications (provided other metrics demonstrate a healthy business).
2. You need to fill a short-term business need: As described above, there are situations where a long-term loan will include a total dollar cost that is too high for the loan purpose. An online loan with a six- to 12-month term could be a better fit.
3. You need an answer regarding your application quickly: Online lenders are typically able to respond with an approval or a decline of your credit application within the same day—sometimes within a few minutes.
4. You need the capital quickly: There are times when opportunity costs are high enough that paying a premium for 24- or 48-hour access to capital is worth the extra expense. For example, the opportunity to purchase quick-turnaround inventory at a discount, could justify paying a premium for the funds.

Qualification Criteria

This may vary from lender to lender, but some general guidelines apply:

• Required Time in Business: Usually between 1-2 years
• Minimum Annual Revenue: $75,000-$250,000
• Minimum Personal Credit Score: 500-650
• Industry: Industry requirements vary by lender, but restricted industries sometimes include financial services, homebuilders, real estate investors, etc.

Make Sure You Know All the Details

Make sure you understand any and all penalties or fees that could be applied to your loan down the road—regardless of whether you apply for a traditional term loan at the bank, an SBA loan, or an online loan. In addition to late fees, is there a penalty or charge for early loan repayment? Do your homework and read all documents carefully. For example, you should understand how frequently you might expect rate changes with a variable rate loan.

If there are financial terms you’re unfamiliar with, make sure they are explained so you can understand them by the lender or have a trusted advisor like your accountant or lawyer review the document and explain the terms to you before you sign it.

With all the options available for small business borrowers today, it’s important for businesses to become savvy about their choices so that they can determine which option will be the best fit for the business.

[1] https://www.sba.gov/loans-grants/see-what-sba-offers/sba-loan-programs/general-small-business-loans-7a/7a-loan-amounts-fees-interest-rates

[2] https://www.sba.gov/loans-grants/see-what-sba-offers/sba-loan-programs/real-estate-equipment-loans-cdc-504/cdc-504-loan-amounts-interest-rates-fees

[3] Federal Deposit Insurance Corporation, Call Report Data. As of June 2012