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A Guide to Choosing the Right Small Business Loan

A Guide to Choosing the Right Small Business Loan
Credit: Duncan Andison/Shutterstock

If you're ready to start a business — or already have one you want to grow — you have three main loan options: government-backed loans, traditional bank loans and loans provided by alternative lenders.

But before you start applying for a loan, you need to answer several critical questions that help you determine which kind of loan is best for you:

  • What do you need the money for?
  • How much money do you need?
  • How long will it take you to pay it back?
  • How long have you been in business?
  • What is the current financial shape of your business?
  • How much collateral, if any, do you have to put up for the loan?
  • How quickly do you need the money?

Answering these questions will help determine if you should pursue a government-backed SBA loan, a loan or line of credit through a bank or other financial institution, a cash advance from a merchant services provider, or a loan from an alternative lender.

Here's a breakdown of what you need to know about each type of loan.

  • The Small Business Administration (SBA) offers several loan programs designed to meet the key financing needs of a wide range of business types.
  • With these loans, the government isn't directly lending small businesses money. Instead, the SBA sets guidelines for loans made by its partners, which include banks, community development organizations and microlending institutions.
  • Businesses have a variety of loan types to choose from when pursuing an SBA loan, each of which comes with its own parameters and stipulations on how the money can be used and when it must be repaid.

Pros and cons: The government guaranty, which typically covers between 75 and 90 percent of the loan, eliminates much of the risk for the lender. In addition, the terms of an SBA loan also tend be more favorable to borrowers. The downsides are that additional paperwork needs to be filed, extra fees need to be paid and it takes longer to get a decision.

What the experts say: "The SBA provides a guaranty that enables the bank to extend credit it would have otherwise declined," Javier Marin, a consultant with the Florida Small Business Development Center at the University of South Florida, told Business News Daily. "This is true for startups, companies with a tight cash-flow stream, and business owners with borderline, not bad, credit scores."

To learn more about specific SBA loans, review the SBA loans portion of the Types of Loans section below.

Editor's Note: Looking for information on business loans? Use the questionnaire below and you will be contacted by alternative lenders ready to discuss your loan needs.  

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While banks are often the sources of SBA loans, they also are lenders of conventional loans.

The biggest difference between SBA bank loans and non-SBA conventional loans is that the government isn't guaranteeing that the bank will get its money back. 

Conventional bank loans give you a little more freedom on what you can do with the money.

While a specific plan is still needed to get approval, bank loans don't come with such stringent use terms that SBA loans do.

Pros and cons: One of the biggest pluses of conventional bank loans is that they carry low interest rates, and because a federal agency is not involved, the approval process can be a little faster. However, these types of loans typically include shorter repayment times than SBA loans and often include balloon payments.  Additionally, it's often difficult to get approved for a conventional bank loan.

What the experts say: "Even though approval rates have increased, big banks approve [only] slightly more than 20 percent of the loan requests they receive," said Rohit Arora, CEO and co-founder of Biz2Credit. "Smaller banks approve a little less than half of the loan applications they receive."

To learn more about specific conventional bank loans, review the conventional bank and alternative lender portion of the Types of Loans section below.

  • Alternative lenders are particularly attractive to small businesses that don't have a stellar financial history.
  • Alternative lenders are becoming a popular choice for startups and established businesses alike because of how quickly the process moves forward.
  • Examples of alternative lenders include the online sites Lendio, Kabbage, OnDeck Capital and Biz2Credit.

Pros and cons: The positives of applying for a loan with an alternative lender are that your business doesn't need to have a perfect financial status and the loans can be approved almost instantly. The downside of using an alternative lender is that interest rates can be significantly higher than those charged by a bank.

What the experts say: "While a borrower is able to get money quickly, he or she pays a premium for that in the form of higher interest rates," Arora said. "Alternative lenders are more willing to provide money to companies that might not have great credit ratings. The increased risk the lenders take is reflected in the interest rate charged."

To learn more about alternative lender loans, see our Best Alternative Lenders for Small Business reviews.

In addition to becoming familiar with the sources of loans, it is critical to understand the types of loans offered. 

SBA loans

Currently, the SBA offers four types of small business loans:

  • 7(a) Loan Program: This is the SBA's primary lending program to help startups and existing small businesses obtain financing. 7(a) loans are the most basic, common and flexible type of loan. They can be used for a variety of general business purposes, including working capital, machinery and equipment, furniture and fixtures, purchase or renovation of land and buildings, leasehold improvements and debt refinancing. These loans have a maximum loan amount of $5 million, and borrowers can apply through a participating lender. Loan maturity is up to 10 years for working capital and generally up to 25 years for fixed assets.
  • Microloan program: The SBA offers very small loans to newly established or growing small businesses. The loans can be used for working capital or the purchase of inventory, supplies, furniture, fixtures, machinery or equipment. The loan cannot be used to pay existing debts or purchase real estate. The SBA makes funds available to specially designated intermediary lenders, which are nonprofit organizations with experience in lending and technical assistance. Those intermediaries then make loans up to $50,000, with the average loan being about $13,000. The loan repayment terms vary based on several factors, including loan amount, planned use of funds, requirements determined by the intermediary lender and the needs of the small business borrower. The maximum repayment term allowed for an SBA microloan is six years.
  • Real estate and equipment loans: The CDC/504 Loan Program provides businesses with long-term fixed-rate financing for major assets, such as land and buildings. The loans are typically structured with the SBA providing 40 percent of the total project costs, a participating lender covering up to 50 percent and the borrower putting up the remaining 10 percent. Funds from a 504 loan can be used to purchase existing buildings, land or long-term machinery; to construct or renovate facilities; or to refinance debt in connection with an expansion of the business. These loans cannot be used for working capital or inventory. The maximum amount of a 504 loan is $5 million, and these loans are available with 10- or 20-year maturity terms. 
  • Disaster loans: The SBA provides low-interest disaster loans to businesses of all sizes. SBA disaster loans can be used to repair or replace real estate, machinery and equipment, as well as inventory and business assets that were damaged or destroyed in a declared disaster. The SBA makes disaster loans of up to $2 million to qualified businesses.

Loans from conventional banks and alternative lenders

In addition to the SBA loans, banks and alternative lenders offer some similar loans, as well as funding options that the SBA doesn't offer, including the following:

  • Working-capital loans: Working-capital loans are designed as short-term solutions for businesses in need of money to help run their operation. These funds can be used to pay bills, make payroll, purchase inventory, etc. Working-capital loans are available from both banks and alternative lenders. The advantage of a working-capital loan is that it gives small businesses the ability to keep their operations running while they search for other ways to increase revenue. Some downsides of a working-capital loan are that they often come with higher interest rates and have short repayment terms. 
  • Equipment loans: In addition to the SBA, both banks and alternative lenders offer their own types of equipment loans. Equipment loans and leases provide money to small businesses for office equipment, like copy machines and computers, or things such as machinery and tools. Instead of paying for the large purchases all at once up front, equipment loans allow business owners to make monthly payments on the items. One benefit of equipment loans is that they are often easier to obtain than some other types of loans because the equipment you're purchasing with the loan serves as collateral. Another positive of equipment loans is that they don't require a large down payment, so they preserve cash flow. In addition, they offer some tax advantages, like write-offs. 
  • Merchant cash advance: A merchant, or business, cash advance is a loan made to a business based on the volume of its monthly credit card transactions. Businesses can typically receive an advance of up to 125 percent of their monthly transaction volume. The terms for repaying a merchant cash advance vary by lender. Some take a fixed amount of money out of a business's merchant account every day until the advance is repaid with the agreed-upon interest, while others take a percentage of the daily credit card sales. The best candidates for merchant cash advances are businesses with strong credit card sales, such as retail merchants, restaurants and service businesses. The advantages of merchant cash advances are that they are relatively easy to obtain, funding can be received as quickly as in a few days and the loan is paid back directly from credit card sales. The biggest downside of a merchant cash advance is that it is expensive. Interest on these loans can run as high as 30 percent a month, depending on the lender and how much money is being borrowed. 
  • Lines of credit: Lines of credit are similar to working-capital loans in that they provide small businesses money for day-to-day cash-flow needs. Lines of credit are not recommended for larger purchases, and are available for as short as 90 days to as long as several years. Typically, traditional banks and financial institutions offer lines of credit. One benefit of a small business line of credit is that you pay interest only on the amount you use. This gives you the ability to take only what you need and pay interest only on what you use and not the entire amount. These loans are usually unsecured and don't require any collateral. They also have longer repayment terms and give you the ability to build up your credit rating if you make the interest payments on time. The downsides of lines of credit are the additional fees charged and that they put small businesses in jeopardy of building up a large amount of debt. 
  • Professional practice loans: Professional practice loans are designed specifically for providers of professional services, such as businesses in the health care, accounting, legal, insurance, engineering, architecture and veterinary fields. These types of loans are typically used for purchasing a practice, buying real estate, renovating office space, buying new equipment and refinancing debt.
  • Franchise startup loans: Franchise startup loans are designed for entrepreneurs who need financing to help open their own franchise business. These loans, offered by banks and alternative lenders, can be used for working capital, or to pay franchise fees, buy equipment and build stores or restaurants.

Now that you've got the basics, you might be ready to make some decisions on which type of loan and provider are right for you. If you're interested in an alternative loan, check out our best picks for alternative lenders.

Still have more questions about the different loan options? No problem. Here are six questions and answers that may help you come to a decision.

Q: If I am applying for an SBA loan, what type of information will the bank ask for?

A: When applying for an SBA loan, small business owners are required to fill out forms and documents for the specific loan they are trying to get. In addition, the SBA encourages borrowers to gather some basic information that all lenders will ask for, regardless of the loan type. The following items are required:

  • Personal background and financial statements
  • Business financial statements
  • Profit and loss statement
  • Projected financial statements
  • Ownership and affiliations
  • Business certificate/license
  • Loan application history
  • Income tax returns
  • Résumés
  • Business overview and history
  • Business lease

Q: What questions will I have to answer when applying for an SBA loan?

A: The SBA advises small businesses applying for a loan to be prepared to answer several questions, including the following:

  • Why are you applying for this loan?
  • How will the loan proceeds be used?
  • What assets need to be purchased, and who are your suppliers?
  • What other business debt do you have, and who are your creditors?
  • Who are the members of your management team?

Q: Where can I find an SBA loan application?

A: Loan applications are available on the SBA website.

Q: What will I need if I'm applying for a conventional loan from a bank?

A: When applying for a bank loan, you'll be required to share all of your financial details. You'll need to provide your lender with all the financial background on your company, future growth plans and often your personal financial information. The more information you have to illustrate that you've run your business well gives banks the confidence they need to invest in you. In addition, you will need to show exactly how you will use the requested money. For example, if you are looking to purchase a new piece of equipment, provide quotes on the exact costs, how much capital you need to facilitate this purchase, and specifically how the new equipment will help grow your business. 

Q: What do I need to consider when applying for a loan through an alternative lender?

A: Experts recommend that, when considering an alternative lender, you take several factors into consideration:

  • Interest rates: Small business owners should know that they can pay off the loan relatively quickly to avoid hefty interest charges.
  • Fees and policies: Be sure to speak with each lender's representative about any fees that may apply when the loan is funded, and how the payback will affect your cash flows, to make sure that you can run your business while paying back the loan.
  • The lender's ratings and review: There are many companies today that say they are alternative lenders, but try to find a company that has an A+ rating with the Better Business Bureau.

Q: What type of information do I need to provide to alternative lenders when applying for a loan?

A: Even though it can be easier to obtain a loan from an alternative lender, you still have to provide them with an array of personal, business and financial information. Not all lenders ask for the same information. Some pieces of information they could request include a plan for how the money will be used, your credit history and a verification of your income and assets. 

If you think an alternative lender is right for you, we encourage you to check out our best picks for various types of loans, as well as our complete lender list if those suggestions don't fit your needs. A roundup of our best picks, our reasoning for picking each and our thorough alternative lender list can be found here.

Editor's Note: Looking for information on business loans? Use the questionnaire below and you will be contacted by alternative lenders ready to discuss your loan needs.  

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Chad  Brooks
Chad Brooks

Chad Brooks is a Chicago-based freelance writer who has nearly 15 years experience in the media business. A graduate of Indiana University, he spent nearly a decade as a staff reporter for the Daily Herald in suburban Chicago, covering a wide array of topics including, local and state government, crime, the legal system and education. Following his years at the newspaper Chad worked in public relations, helping promote small businesses throughout the U.S. Follow him on Twitter.