Business loans are among the most common forms of financing available. Securing a loan, however, can be confusing. What amount of money do you need to borrow? How do you know if you qualify? What types of loans are available? All these questions and more can delay — or completely prevent — the decision to seek necessary outside funding.
Documentation for a loan application process requires tax returns, bank statements, business financial statements, legal documents (like articles of incorporation), and your formal business plan.
If thinking about financing, here five critical steps to ensure you get the best loan that addresses your specific business needs:
Step 1: Understand Your Credit Score (and any errors)
Know your credit score inside and out.
Lenders use this to gauge how dependable you are when it comes to paying back personal debts.
Credit scores range from 300 to 850 (the higher, the better), and are available for free on sites like NerdWallet or CreditKarma; copies of your full credit report are available at sites like AnnualCreditReport.com, which offers access to each of your credit reports from the three major credit bureaus — Equifax, Experian, and TransUnion — at no cost.
Note any potential errors in your report or red flags that might hurt your eligibility, like a history of delinquent payments or major purchases made on a compromised card.
Step 2. Determine what size loan your business needs
Lenders want to know exactly how much you need, why you need it, and how you plan to put it to use.
Are you looking to cover startup costs, finance equipment, cover rent for a storefront, cover payroll, or even take advantage of new product development? Whatever goals you have, the most important thing here is to be clear about your ideal outcome. How much do you need? The amount you decide on here will also play a significant role in the type of loan you’ll need to pursue. For example, if you need less than $50,000, you can apply for a microloan, but you’ll have to research other options for a larger loan.
Step 3. Calculate the debt you can afford
Lenders will be more likely to approve your application if you can prove how you’ll pay them back. To do such, calculate your debt service cover ratio, or your DSCR. Simply divide your cash flow by your estimated loan payment.
If your cash flow hovers around $3,000 per month, and you project the monthly payment on your small business loan will be $800, your DSCR is 3.75. In general, your lender will want to see a DSCR that’s larger than one. When that number is lower, it tells lenders that you won’t have the cash needed to pay them back.
Step 4. Determine type of loan
Depending on the unique business needs there are different routes to consider:
- First-time entrepreneur starting a new business. This can be challenging as lenders require evidence of cash flow to support repayment of the loan. Other options include business credit cards or personal loans.
- Line of credit to cover day-to-day expenses. A line of credit provides the flexibility that a regular business loan doesn’t, and it works just like a credit card. You can borrow up to a certain limit — like $80,000 — and pay interest only on the amount you borrow. You can also draw and repay the funds on your own schedule if it stays within your credit limit.
- Expand existing business. If you need a loan to expand an existing business, a U.S. Small Business Administration (SBA) or traditional bank loan might be the best option. Both allow you to borrow large sums of money.
Step 5: Decide where to secure the loan
Once type of loan is determined there are three main ways to secure the loan:
- Online lenders. Online lenders are ideal if you lack collateral or business experience, or you need funding quickly. They offer loans and lines of credits ranging from $5,000 to as much as $1 million. However, they might come with higher annual percentage rates (APR), ranging from 6% to a whopping 99% — so make sure you do conduct thorough research. Your APR will depend on the lender, the size of your loan, the length of the repayment term, and your credit history.
- Banks. A business loan from a bank is ideal if your business has been up and running for at least two years, with strong credit, and you aren’t in a rush to get cash. When you go this route, you’ll have different options, including term loans, lines of credit, or commercial mortgages to finance your store. Note that the SBA works with selected banks to guarantee a portion of loans they make to small businesses, and in general, they can offer loans up to $5.5 million. However, the average SBA loan hovers around $633,000. Getting funding from a bank takes longer than the other options, but offer the lowest APR.
- Microlenders. Microlenders can cover expenses when the other two options are unfavorable. Consider this type of loan if your credit history is a little rocky, you have no credit history at all, or new to running a business and unable to get approval for a traditional loan.
As the name suggests, microlenders are nonprofit organizations that lend out smaller loans, usually less than $50,000. However, the APR on these loans is higher than traditional bank loans.
Finally, while the actual application process varies depending on the type of loan and lender you choose, don’t limit yourself to just one option. Take enough time to shop around for the best terms and APR rates, and make sure you calculate the total cost of the loan for the year across each. ###
Travis Crabtree is President of online business filing company Swyft Filings, which helps entrepreneurs in every state navigate and automate the new business filing process. Crabtree is an expert in brand management and protection, online marketing, risk management, and privacy issues.