Small Business Loans

Business Loans: How Do They Work?

Updated: June 15th, 2020

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As a business owner, the chances are likely that the time will come when you could use some extra capital. This is especially true in these uncertain economic times, with no segment of the economy, including small businesses unscathed by the effects of the coronavirus pandemic. According to a JPMorgan report cited in The Wall Street Journal, nearly half of all small businesses have just enough cash liquidity to last for less than two weeks. 

The good news is that you’re in good company. And, how business loans work is that they are tailored especially for you, the business owner.  Online lending platform Funding Circle recently announced that business owners borrowed more than $10 billion through its platform globally, as of August 2019.

The need for financing could be for one of many reasons, big or small, ranging from a lull in cash flow in an emergency to an expansion to replenishing inventory to hiring. While you can use a business loan toward these and other purposes, there are boundaries. For instance, your business loan doesn’t apply to your personal finances.  

What other rules and information should you know when it comes to answering the question, “how do business loans work?” Let’s dive in and discuss. 

The Mechanics of How Small Business Loans Work

Whatever the need, you may be wondering if pursuing a business loan is the right path for you.  While securing a business loan can be quick and flexible, it helps to know the nuts and bolts of how small business loans work. 

In a nutshell, the way that business loans work is a lender, which could be a group of investors, extends capital to an applicant – in this case, the business owner. The business owner then must repay the lender in monthly installments over a preset period of time at a fixed interest rate, plus any potential fees. These might be deducted from the loan amount, for example. 

Lenders like Funding Circle are upfront about the fee structure, so there aren’t any surprises later on. Repayment terms differ based on the type of loan, etc. so let’s dive right into the details. 

Where Do I Start? 

When the wheels begin turning about questions like “how do business loans work?”, the first thing that might pop into your head is whether or not you’ll qualify. While you’ll have to apply to know for sure, you can certainly take steps ahead of time. 

For example, in addition to being credit-worthy, which should be reflected in your personal and business credit scores, expect to have a couple of years of operating history under your belt to qualify for a business loan. If you meet these early criteria, you are well on your way to getting a loan, whether you need $50,000 or $500,000.  

The next question you may have around how small business loans work is where to turn to in order to receive financing? Gone are the days where you need to apply for a loan in person at your local bank branch. In the past, you’d need to fill out mounds of paperwork before waiting weeks for a decision. The rise of online lenders has streamlined the process so that you can apply for a business loan without leaving your desk and receive a response in as little as two working days or less. 

That doesn’t mean you won’t have support, as online business loan lenders like Funding Circle will assign you an account specialist once the application process is underway. With an online lender, you can expect to complete your online application in a matter of minutes. Applying won’t affect your credit score, and there’s no fee to apply. Once you’re approved, you could have the funds in your account in as quickly as 24 hours. 

How Do Business Loans Work: Types of Loans

Installment loans 

Term loans for small businesses belong under the installment loan umbrella. As the name suggests, you repay this loan in installments, which are generally monthly. You receive the funds in a lump-sum at the start of the loan, minus any fees. If you use an online lender, you can generally expect the funds to be deposited directly into your bank account, the details for which the lender will typically collect during the application process. 

Next, you begin repaying the loan with a fixed payment amount, a portion of which will go toward the interest and the remainder of which will go toward the principal amount. This amount is calculated based on the amount of the loan, the term of the loan, and the interest rate.  A key benefit of a term loan is that the payment terms are known, so unlike the typical day of a business owner, there are no surprises. 

The fixed structure of a term loan comes in handy when it comes to budgeting. Not all term loans were created equal, however. Some may contain variable rates that fluctuate with the economy or have a more rigorous repayment schedule, so be sure to be clear on all details before signing up.

Continue making payments until the loan is paid in full, at which time the account becomes closed. At Funding Circle, you only pay for the amount of time you have the loan, so if you pay early, you won’t receive a penalty. 

Secured vs. Unsecured

Term loans are broken down into two types: secured or unsecured. 

A secured business loan is backed by your collateral, such as equipment, vehicles, and inventory, to name a few possibilities. Banks will generally offer secured loans and are likely to take a lien worth the value of the collateral assets to offset the risk of default. If the borrower defaults, the lender is entitled to the asset backing the business loan. 

How unsecured business loans work, however, is that they require no collateral. But, they are less common except for gaining access to financing via credit cards (discussed in more detail below).  

Term loans can be short-term or long-term in nature. 

Revolving Loans 

You might also come across business credit cards and lines of credit, both of which fall under the revolving loans umbrella. How do business loans work in this situation? Well, you are given access to a certain amount of credit that becomes accessible to you at the start of the agreement. 

As you make withdrawals, the amount of credit you can use drops commensurate with the drawdown amount. True to its name, this business loan is revolving. So, after you repay the amount you borrowed, the credit becomes available for you to borrow once again. 

Cash Flow 

If you like the idea of the installment loan, you might also find a cash-flow business loan interesting. With this type of business loan, you similarly get the cash in a lump-sum amount. The primary difference comes in with repayment, which is tied to your business’ cash flow instead of a fixed monthly payment amount. 

Additional financing options

A merchant cash advance (MCA) is not technically a loan, but it’s a reasonable example. In this case, you promise a percentage of your credit and debit card sales to the issuer of the financing. Invoice financing works similarly but depends on your accounts receivable. Repayment is tied to your customers paying their invoices. 

Now that you are armed with more information about how small business loans work, the ball is in your court. Contact Funding Circle to learn more about our business financing options.

Funding Circle, the largest small business lending fintech is one of a few non-depository online lenders in the United States that was recently approved to provide Paycheck Protection Program loans. We offer the PPP application in four languages: English, Spanish, Mandarin and Hindi.

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