What are business loans and how do they work?

In a nutshell

Small business loans and lines of credit are some of the most common types of funding small businesses rely on. These loans can help small businesses access $100,000 or more in loan funds, and many offer fast funding — sometimes as soon as the day they're applied for or the next business day.

• Small business loans are available from a range of online lenders, as well as traditional banks and credit unions.
• They can be either secured with collateral or unsecured.
• There are many small business loan types, including term loans, business lines of credit, government-backed Small Business Administration (SBA) loans, invoice factoring, and others.

How do business loans work?

The exact way business loans work depends on the type of financing being offered. For example, term loans and SBA loans offer businesses a lump sum of cash that they pay back over time with a set monthly payment and fixed repayment term. On the other hand, business lines of credit let companies borrow money and pay it back only as they need it.

Other types of business loans let small businesses borrow against or sell their outstanding invoices, or even borrow against their future revenue. Depending on the type of small business loan, regular payments may be required on a weekly or monthly basis.

Some business loans require collateral, and this collateral can come in the form of a lien on business assets. Many business loans also require a personal guarantee. This means that business owners themselves are personally liable for repayment — even if the business fails — and that lenders can come after their personal assets if they default on the loan.

Note: Small business loans can help build both personal credit and business credit scores. For the best possible results, companies will want to make all payments early or on time and follow all the terms and conditions of their loan agreement.

Types of business loans

Common types of business funding available today include term loans, lines of credit, and others. Read on for an overview of popular business loan types.

Term loans

Term loans let borrowers access a lump sum of cash and pay it back over a set repayment term. Interest rates tend to be more competitive for term business loans than some other types of financing, although minimum eligibility requirements are also higher. For example, you may need to have $50,000 to $100,000 (or more) in annual revenue to qualify for some business loans, have operated your business for a certain number of years, and have a good credit score.

Business term loans are offered in amounts that vary by lender, with some offering as little as $5,000, all the way up to $2 million.

Business lines of credit

Small business lines of credit allow businesses to access a line of credit that they can borrow from when they need to. This means companies can borrow as little or as much as they want (up to a certain limit), and their regular payments will be based on the loan amount.

Business lines of credit tend to come with lower limits overall, with maximum loan amounts up to $100,000, $250,000, or $500,000 across most lenders. Repayment terms tend to be shorter as well, usually up to 24 months.

Invoice factoring

Invoice factoring is a type of financing that lets business owners sell their outstanding invoices to a third party, and the third party gives them a lump sum payment. From there, businesses pay rates and discount fees to the company, reducing their net income.

The benefit of invoice factoring is that eligibility requirements are lower. Business owners are borrowing against amounts they owe — and using outstanding invoices as collateral — so there is often no need for a credit check.

Merchant cash advance

A merchant cash advance lets businesses with solid revenue borrow against their future earnings. Traditional eligibility requirements (like minimum credit scores) don't apply.

Merchant cash advance amounts are also based on the projected income of a company, although amounts from $5,000 to $500,000 are common. Fees and interest charges also apply and vary by lender.

Small Business Administration (SBA) loans

Government-backed SBA loans follow guidelines set by the U.S. Small Business Administration, and they feature higher loan amounts (often up to $5 million) and more stringent eligibility requirements. These loans can also require several months for funding, so they're best for small businesses that aren't in an immediate cash crunch.

While the terms of SBA loans vary, these loans are popular due to their competitive interest rates and lengthy repayment terms (up to 25 years).

Equipment financing loans

Equipment financing loans are popular for businesses that need to invest in expensive equipment over time, including those that operate in industries like farming, manufacturing, and transportation. Loan amounts, interest rates, and terms vary by loan company, although the maximum amount available is typically based on the cost of the equipment being financed.

Typical loan amounts can be from $5,000 to $5 million, with repayment terms that last up to 10 years.

How to qualify for a business loan

Business loan eligibility requirements vary widely across business lenders and loan types, and some lenders are more transparent about their requirements than others. That said, you'll have the best chance at business financing if you've been in business for several years (at minimum), you have a strong personal credit score, and your annual business revenue is more than $100,000 — and predictable from one month to the next.

Basic business loan requirements include:

• Annual revenue requirements: Business lenders require applicants to have a certain amount of monthly or annual business revenue, although these requirements vary. For example, OnDeck loans require a minimum business revenue of $100,000, whereas Bluevine requires applicants to have at least $480,000 in annual business revenue to qualify for its business lines of credit.
• Collateral: Some business loans require some sort of collateral to be approved, which could be a lien against business assets. For real estate loans, the property the loan is used to purchase is used as collateral.
• Minimum credit score requirements: Minimum credit score requirements also come into play with business financing, although these requirements vary widely. Some business lenders require a minimum credit score as low as 580, while others require scores of 660 or higher.
• Other debts: Business lenders will also look at your personal and business debt-to-income ratio before approving you for a loan. If your existing debts are too high in their eyes, you may struggle to be approved (even if you meet other eligibility requirements).
• Personal guarantee: Most business loans require applicants to provide a personal guarantee that says they'll pay back the loan. Personal guarantees also make it possible for lenders to go after the business owner's personal assets if they default on their loan.
• Time in business: Lenders also want to lend money to companies that have been around for a while. Some lenders require at least one year in business, while others require two years in operation (or longer).

Business loans vs. personal loans

While business loans extend financing to small businesses, entrepreneurs, and self-employed business owners who need access to capital, personal loans can also provide a much-needed source of funding.

Personal loans are unsecured with no collateral requirements, and they typically let borrowers access between $2,500 and $100,000 in funds (depending on the lender) with repayment terms that can last from 12 to 84 months and potentially longer. Personal loans are also a predictable way to borrow money since they come with fixed interest rates, fixed monthly payments, and a set repayment schedule that borrowers agree to when they apply.

Frequently asked questions (FAQs)

Do business loans hurt your credit?

Applying for a business loan can result in a hard inquiry on your credit report, and this can temporarily affect your personal credit score. However, making on-time payments and paying back the amount borrowed should help you improve your credit over time.

What are the disadvantages of a business loan?

The disadvantages of small business loans vary based on the type of loan. Some potential downsides include high interest rates (especially for imperfect personal credit), short repayment terms for some loans, and difficulty getting approved. Businesses that are newer and have low revenue right now may struggle to find a company that will approve them for financing.

What is the minimum credit score for a business loan?

Minimum credit score requirements for business loans vary, but they can be as low as 580. Most lenders require a minimum score of FICO 625 or higher.