Okay, let’s set the stage: you have a growing business and you’re looking for working capital. After careful consideration and deliberation, you’ve decided that a business loan is the right choice for you and your business.
Now, the question is “What type of loan should I get, and from which lender?” There are a lot of loan options out there, each with their own pros and cons. And unfortunately, some of them come with unexpected costs and consequences.
To make an informed, confident decision, you need to understand the different loan options that are available, the key underlying differences between them, and how to evaluate them side-by-side. Here’s what you need to know.
- Understanding different types of business loans
- Types of lenders
- How to compare business loan options
Understanding different types of loans
How many types of business loans are there? It depends on how you categorize them. This article lists seventeen, while this one lists a mere seven. Instead of trying to define an exact number, let’s talk about the key differences between different types of loans.
Term loans vs. lines of credit
Most loans fall into one of two main categories based on how the funds are withdrawn and repaid.
- Term loan: With a term loan, you’ll borrow a lump sum and repay it over a pre-specified period of time. Mortgages, auto loans, equipment financing, and many other loans fall into this broader category.
- Line of credit: If you get a line of credit, you are pre-qualified to borrow any amount up to a certain limit. You can withdraw funds up to the maximum and you’ll only pay interest on the amount you borrow. Credit cards are considered to be a revolving line of credit.
Secured vs. unsecured loans
If a loan is secured, it means the borrower has pledged collateral (usually valuable property like a house, a car, or equipment) to the lender; if the borrower can’t make their payments, the lender has the ability to take this property. Mortgages, car loans, and equipment loans are common secured loans; with these loans, the asset that the borrower purchases with the loan is considered collateral.
Unsecured loans don’t require collateral. This type of loan is riskier for the lender, so they typically come with higher interest rates or stricter qualification requirements.
Loan programs through nonprofits and government agencies
Some nonprofits, economic development centers, and government agencies offer loan programs for business owners.
The most well-known loans within this category are SBA (Small Business Administration) loans. Your city, state, or local business development center may also offer loan programs or resources. These loans often have desirable terms like low interest rates and modest fees, but they also often come with specific eligibility requirements.
Financing options that aren’t technically loans
When you’re researching different options for funding your business, you might hear about invoice factoring and merchant cash advances. With these methods, the financing provider will give you cash up front in exchange for future sales or revenue from unpaid invoices. These financing methods aren’t technically loans, but they work very similarly to secured, short-term loans.
Types of lenders
In addition to understanding the primary types of loans, it’s helpful to have a basic understanding of the lenders who offer them.
Banks and credit unions
Banks and credit unions are the first options that spring to mind, for many people, when they think of a business loan. Of course, the options vary from one institution to another, but there are few general commonalities to keep in mind:
- Often banks and credit unions will offer credit cards, lines of credit, and term loans to business owners. They may also offer equipment loans or auto loans.
- Big banks tend to have low approval ratings for business loans, while smaller banks and credit unions approve a significantly higher number of applications according to the Biz2Credit Small Business Lending Index.™
After the financial crisis in 2008, the approval ratings for small business loans at banks plummeted and thousands of entrepreneurs were left without a lot of options for getting working capital. In the years since then, there’s been a proliferation of online lenders, including LendingClub, Kabbage, OnDeck, Camino Financial, and many others.
Online lenders often carve out their own niche market of customers who aren’t served or satisfied by more traditional lenders like banks.
- Many online lenders focus on offering a quick, streamlined borrowing process, allowing business owners to apply and withdraw funds within a matter of days.
- Online lenders may offer a wider range of financing options than traditional lenders, including invoice factoring and merchant cash advances.
- Some online lenders specialize in serving customers who aren’t able to get the type of credit they need from traditional lenders. For example, they may offer loans to entrepreneurs with poor or limited personal credit.
How to compare loan options
Now that you’re armed with an understanding of the different types of loans and lenders out there, it’s time to start looking at specific loan options. You can use a business loan comparison tool like this one or this one, or compile a list of potential lenders and research them one by one.
Once you find a handful of options that look promising, here are three questions that you should ask before you apply:
1. Will you qualify?
Unlike personal loans, which tend to have straightforward eligibility requirements (if you have the right credit score, you’re in!), business lenders can look at a wide range of criteria. For example, they might consider the answers to any or all of the following questions:
- How long have you been in business?
- Do you have a business credit history?
- What’s your revenue?
- What’s your personal credit?
- Will the loan be secured with collateral?
Often, a lender will have different requirements for each type of loan they offer. If you don’t meet the eligibility requirements for one type of loan, that doesn’t mean the lender is off the table; you can always ask if they offer a different type of loan product that’s a better fit for your business.
2. Are your personal assets or credit at risk?
Many lenders will ask for a “personal guarantee” when you take out a business loan. A personal guarantee means that you’re pledging the lender that you’ll use personal assets to repay the loan if you’re not able to make the payments using your business assets. If you offer a personal guarantee, it’s possible that the business loan will affect your personal credit.
If your business is relatively new and doesn’t have established revenue or credit history, it’s more likely that you’ll need to offer your lender a personal guarantee in order to qualify.
3. What are all the costs involved?
Loans cost money. That much is obvious, but the total cost can be surprisingly tricky to find because many loans include fees as well as interest charges. Here are some common costs and fees to watch for:
- Interest: This is the cost you pay in order to use the money you borrow. Your interest rate may be fixed or variable. Pay attention to both the APR (annual percentage rate) and the total amount of interest that you’ll pay for the life of the loan.
- Upfront fees: When you take out a loan, you may be charged an origination fee, an underwriting fee, or closing costs. All of these fees are charged up-front when the loan is issued.
- Late fees and other servicing fees: Many lenders will charge a fee if you don’t make a payment on time. They might charge fees for specific services, like cash advances.
- Annual fees: Lines of credit (including credit cards) may come with an annual fee.
- Early repayment fees: Some lenders will charge a fee if you repay a loan early, which means you’ll either pay a penalty or be locked into paying interest for the entire life of the loan.
When you’re shopping around for a loan, it’s the total cost that matters—so make sure you have all the information you need to calculate it accurately.
To sum things up
Choosing the right business loan is a high-stakes project because it can have a profound impact on the long-term financial health of you and your business. As a result, it’s a decision that’s best approached with a strategy and plenty of curiosity.
Now that you’ve taken the time to research and understand the specific characteristics that distinguish one loan option from another, you’re ready to evaluate all the options side-by-side and find the very best fit your business.
Disclaimer – This content is for informational purposes only and does not constitute tax, accounting, legal, or other professional advice. Please do not rely on this content for any specific purpose without obtaining personalized professional advice.