How to Decide Which Type of Business Loan Is Right for You

Types of business loans

Friends and family loan

This is typically the first stop for business owners who are looking to get an enterprise off the ground. It can also be used by established businesses for cash flow or to chase growth. If you ask your friends and family to lend you money, it’s vital to put everything in writing. Otherwise, you open the door to misunderstandings that can chill your relationships. Also, you should have documentation of the loan’s terms in case the IRS decides to audit your business.

Conditions

Borrowing from friends and families carries risk. Be sure to overcommunicate the value you bring to your customers and demonstrate how your friends and family will be part of the business. You should provide a written promissory note stating how much money they can expect you to pay back and at what interest rate. With this note, you’ll also want to specify a repayment schedule in writing.

Benefits

Money borrowed from friends and family can come with the best repayment plan you’ll ever get. This is one of the best reasons to borrow money from friends and family instead of from banks and commercial lenders. You may also expand your sales force when you borrow money from those you know; when they’re financially invested (in addition to being personally invested as someone who loves you), they may take it upon themselves to help you succeed and reach your business goals.

How to apply

To show you’re serious about requesting funding from relatives or friends, you may want to approach the subject formally, armed with your business plan, projections and outlines of how you’ll use the money; specifications on your friends’ and family’s involvement in your business financing; and suggested loan terms and repayment terms. 

Editor’s note: Looking for a small business loan? Fill out the questionnaire below to have our vendor partners contact you about your needs.

Business line of credit

A business line of credit is a flexible business loan that allows you to pay interest only on the portion of money you borrow. It works similarly to a business credit card in that you may draw funds as needed and repay them as you can, as long as you do not exceed your credit limit. This is an excellent option for businesses looking for an easy way to manage their cash flow, purchase inventory or pay for a surprise expense.

Conditions

A business line of credit works like a credit card, allowing you to take out and repay the money on your own terms as long as you stay within your credit limit and make payments on time. Most lenders will allow you to pay off your balance early to keep your interest costs down.

Line-of-credit limits tend to be lower than business term loan amounts — generally from $1,000 to $250,000 — and are unsecured, so you typically do not need to put up collateral except in the case of a larger line of credit. Fundbox, one of our small business loan best picks, offers lines of credit as high as $150,000. Learn more in our review of Fundbox.

Benefits

Business lines of credit are a flexible option that allows you to manage your business’s cash flow as you see fit, and you can reuse and repay your credit as often as you need to.

How to apply

Similar to business term loans, you can get a business line of credit from either a traditional bank or an online lender. Banks will require your business to have strong revenue and one to three years of positive history to qualify, as well as the following documentation:

• Tax returns (business and personal)
• Bank account information
• Business financial statements

Online lenders generally have fewer restrictions and qualifications than banks do, but they tend to charge higher interest rates and have lower credit limits.

Working capital loan

Working capital loans are short-term business loans designed to bring extra cash into the business to use for growth and expansion as well as for day-to-day expenses, such as advertising, payroll and inventory purchases. You can also use working capital loans to cover emergency costs or to pay down debt.

Conditions

Working capital loans require you and your business to meet certain thresholds for time in business, monthly or annual sales, and credit score. The qualifications vary from one lender to the next. One top lender, Fora Financial, requires borrowers to be in business for at least six months, have sales of at least $12,000 per month and have a decent credit score. Learn more in our review of Fora Financial.

Benefits

Working capital loans usually have low interest rates. The better your credit score is, the lower the cost to borrow will be. 

How to apply

When you apply, start with the bank you already do business with. It will not only have access to a lot of your financial information but also will be able to review your existing banking and credit habits to assess risk. If you get turned down, consider alternative lenders. 

Business term loan

A business term loan is a lump sum of capital you pay back in regular payments at a fixed interest rate for a set period of time — which is where the “term” part comes in. The term is generally three to 10 years.

Conditions

The purpose of a business term loan is to allow you to finance a large purchase, such as equipment or a new facility. There are few restrictions on a business term loan, and most businesses that have sales and good credit will qualify.

With a business term loan, you get a predetermined amount of money and a fixed interest rate to be repaid over a set number of years. The loan amount will depend on your business and its needs, but it’s generally $25,000 to $500,000, with interest rates from 7 percent to 40 percent. SBG Funding, one of the best business loan options, lends small businesses up to $5 million. Terms range from six months to five years. Learn more in our review of SBG Funding.

Benefits

A business term loan generally has few restrictions and can help you build your business by introducing capital to purchase new office equipment. These loans can also be used to build inventory, to cover cash-flow gaps or to invest in a new opportunity. 

How to apply

You have a couple of options when applying for a business term loan. These loans are traditionally available through banks, though they often have a long and arduous application process. Several banks offer expedited online applications, though. These are some of the documents you’ll need:

• Driver’s license
• Voided business check
• Bank statements
• Balance sheet
• Credit score
• Tax returns (personal and business)
• Profit and loss statements

>>Read About: Loan Payment Calculator

Small Business Administration (SBA) loans

SBA loans are government-backed loans that are available to small businesses from private-sector lenders. These are secured loans, meaning you must pledge your company or personal assets as collateral. There are three SBA loan programs:

1. The 7(a) loan program is the SBA’s primary program for providing assistance to small businesses. The terms and conditions vary by loan, and loan amounts range from $350,000 to $5 million.
2. The microloan program provides the smallest loan amounts available from the SBA, ranging from $10,000 to $50,000. Microloans are ideal for small startups, borrowers with limited collateral or companies that just need a small financial boost.
3. The CDC/504 loan program offers loans to small businesses with long-term fixed-rate financing for the purposes of expansion or modernization, such as large equipment or real estate purchases. These are typically larger loans, usually with a $5.5 million maximum. Terms are 10, 20 or 25 years, depending on the purpose of the loan.

Conditions

There are multiple conditions under which SBA loans cannot be issued, including if a business is operating as a nonprofit or is not based in the United States. SBA loans cannot be used to repay delinquent state or federal withholding taxes.

Terms vary by the size of the loan, the planned use of the money and your needs as a small business borrower. The maximum term allowed for a microloan is six years. Interest rates are usually 8 percent to 13 percent.

Benefits

Each SBA loan has its own benefits. For instance, a 7(a) loan is extremely versatile and can be used to purchase land or buildings, cover new construction, finance equipment or other supplies, or acquire an existing business.

Microloans may be available to businesses that otherwise wouldn’t qualify for a loan. They can be used in multiple ways: as working capital; for inventory, supplies, furniture and fixtures; or for machinery and equipment.

A 504 loan, which borrowers typically use to buy commercial real estate or heavy equipment, offers short-term and long-term benefits, including 90 percent financing, longer loan amortizations, fixed interest rates and overall savings.

How to apply

Each program has specific eligibility criteria and an application process. Visit the SBA website for information on how to apply for an SBA loan and for checklists to ensure you have everything you need to complete your application.

Accounts receivable factoring

Accounts receivable factoring is also known as receivable financing. This type of business loan is used to convert sales on credit terms for immediate cash flow. For example, if you provide outsourced marketing services to large enterprise clients, you might sell your existing, uncollected invoices (which you are waiting on payment for) to a third party for an advance payment. This third party, called the factor, provides you with the full or partial amount and then collects on the sale from your customer. This type of financing is generally used to buy your small business some time while you look for more long-term, sustainable funding sources.

Conditions

This receivable credit line can be costly, so you should exhaust all other financing efforts before turning to it. Once you factor in a discount fee, interest rates of 10 percent to 25 percent and other charges, you could end up paying much more over time than you would with other financing options. Also, your financing is determined by the financial strength of your customer, not you as a seller of goods or services. Most invoices over 90 days old will not get financed, and invoices that are paid out more quickly will afford you more beneficial terms.

Benefits

One of the greatest advantages of this type of business loan is that it allows you to cash in immediately on your future receivables; you won’t have the majority of your capital tied up in inventory or unpaid invoices. It may also be beneficial to outsource your accounts receivable management to another company, thereby freeing you to focus on productive work for your business. This funding is also faster than many options, as you don’t have to provide a business plan or tax statements. When reviewing factoring companies for our best picks, we found Bluevine to be among the fastest to fund. 

How to apply

Most companies that offer accounts receivable financing are commercial lenders, not banks. To apply for accounts receivable financing, you’ll have to fill out an application and hand over your articles of incorporation, your company’s most recent accounts receivable and payable reports, a master customer list and an example of your typical invoice.

Merchant cash advance

A merchant cash advance isn’t technically a loan but rather a cash advance based on the credit card sales deposited into your merchant account.

Merchant cash advances are quick; the funds are often deposited 24 hours after approval. Historically, merchant cash advances have been used by businesses that subsist primarily on credit and debit card sales, such as restaurants and retailers, but they have become available to other businesses that do not rely on card payments alone.

Conditions

With a merchant cash advance, you receive an upfront sum of cash in exchange for a portion of your future credit and debit card sales or fixed daily or weekly debits directly from your bank account. 

Merchant loan advances provide you with fast money but carry high annual percentage rates that consist of the total cost of the loan plus all fees. They can run your business into debt quickly if you are not careful.

Your fee amount is determined by your ability to repay the merchant cash advance. The provider will determine a factor rate of 1.2 to 1.5 based on a risk assessment. The higher the factor rate, the higher your fees. Your total repayment amount is the factor rate times the cash advance.

Benefits

The main draw of merchant cash advances is that they are fast; you could have cash in hand less than a week after submission, with little or no paperwork. Merchant cash advances are also unsecured, which means you do not have to put up collateral, and repayments will adjust to how well your business is doing.

How to apply

Applying for a merchant cash advance is simple. Start by looking at online business lenders and filling out their online applications. Expect to provide three months’ worth of financial statements.

How to decide which type of business loan is right for you

Before you choose a business loan, it’s important to remember that all business loans operate under a similar principle: A lender provides you with funds that you repay, along with fees and potentially interest, over a predetermined period. However, the specifics of each loan will vary based on your business’s financial needs and status, as well as the terms of different lenders.

Take the following steps to determine the right business loan for you:

• Consider your financial needs. Determine how much you need to borrow and under what terms. Review your credit score and history, which are key in determining which loans will be available to you.
• Identify collateral requirements for each loan. Lenders mitigate the risk of loan defaults by requiring collateral, which can vary, with some lenders allowing or mandating the use of personal assets as security for a business loan.
• Analyze the lender’s reputation, as well as the loan terms and interest rates, which will be based on credit and other risk factors.

Danielle Fallon-O’Leary and Kiely Kuligowski contributed to this article.