A recent survey has suggested that the vast majority of business loans were used to purchase equipment and inventory, with most borrowers expecting that for every dollar they borrowed it would increase by 400 percent.
Contrary to popular belief, debts are not always bad. They can be used to propel business growth. Basically, ‘good’ debts carry low interest rates that allow you to invest funds to produce a higher return on capital over time.
What Is the Purpose of Business Loans?
Business loans are not created equal. To help you find the ideal loan for your needs, the most critical question is why you need one in the first place. If you’re able to articulate its purpose, you can answer some other pertinent questions that will lead you to finding the best lenders to meet your financial goals.
If you need extra financing for inventories, which is not uncommon in seasonal businesses like holiday retailers, a short-term loan makes more sense than a long-term loan. Meanwhile, long-term loans that usually have a 4-5 year duration, are better if you need extra funding to purchase a large asset such as a property or a piece of heavy equipment. In this scenario, the use of short-term loans could make it extra difficult to meet your financial obligations due to large monthly payments, which could put a strain on your cash flow.
As a general rule, long-term loans have a lower periodic payment, which could make it easy for your business to maintain a healthy cash flow. They also come with lower interest rates than short-term loans although the total cost of the loan is higher because of their accruing interest. Surveys have shown that more than half of small business loans were short-term loans which were repaid in less than a year, as borrowers sought to minimize the total interest cost. This is true even if the short-term loans come with a higher APR than long-term loans.
Is a Business Loan Necessary?
You should only seek business loans when the funds can increase your returns on investment or propel your business growth. If not, avoid them because of the gratuitous costs associated with borrowing. This contradicts a popular belief that one should borrow as much money as possible, even when there is no concrete plan on how to use the additional funding.
Always view business loans as a unique opportunity that will add value to your business. After all, you never know when you can borrow extra funds again.
How to Get a Business Loan?
After you determine why you need a business loan, the next step is to look for the best lender that will meet your needs. A good rule of thumb is to compare multiple lenders based on interest rates, loan terms, and other provisions. Furthermore, choose a lender that has the lowest interest rate and offers payment terms that will not have a detrimental effect on your cash flow. Banks generally have a lower annual percentage rate or APR than microlenders and online lenders.
But as with any financing option, business loans from banks come with these caveats:
- Usually require collateral
- You must have a good credit score
- Loan approval may take 2-6 months
- May not always cater to situations where a microloan would suffice
Microlending is another option for small businesses although it often comes with higher interest rates and processing costs than bank loans. Nevertheless, this financing tool suits smaller companies and start-ups that are often denied by traditional lenders because of their lower sales volume, insufficient operating history, poor cash reserves, and/or poor personal credit.
Other benefits of business loans from microlenders include higher approval rates and quicker funding.
Of course, extra funding from microlenders also comes with some downsides such as:
- Two-digit interest rate (10 percent on average)
- Business loan applications often entail a detailed business plan and financial statements
Many online lenders operate similarly to microlenders, although they typically have higher interest rates which depend on the size and type of loan, repayment term, use of collateral, and credit history of the borrower. Nonetheless, they offer one notable advantage: funding is significantly faster than with traditional banks, sometimes as fast as 1-2 days.
Once you find the right lender, the next step is to submit these following documents:
- Business and personal tax returns
- Financial statements of your company
- Business and personal bank statements
- Legal documents such as articles of incorporation, franchise agreement, etc.
When your business loans have a definitive purpose, it becomes much easier to find the ideal lenders based on the repayment terms, interest rates, and other provisions. A good rule of thumb is to choose a financing option that offers the lowest APR and loan terms that you can handle.