Successful entrepreneurs aren't afraid to borrow money because they know how to manage debt. By taking out a small business loan or business line of credit, they stay ahead of the competition, get a cash boost, and put their businesses in a position to make more money.
According to Forbes, small business loan approvals rose to 27.5% for big banks and 49.8% for small banks in 2019. Additionally, banks now partner with fintechs to improve a borrower's user experience.
But how do you decide which type of financing is better for your business? Should you get a small business loan or a line of credit? That's the topic of this post. You'll learn how to determine which financial instrument suits your business model.
Small Business Loans
Start-ups and established businesses can access funds from traditional banks, online lenders, and credit unions. The major types of small business loans are listed below.
Small Business Administration (SBA)
According to Experian, the global leader in consumer and business credit reporting, business owners with good credit are the best candidates for government-backed SBA loans, in which the organization partially guarantees through banks to lessen a lender's risk. Depending on the type of SBA loan an entrepreneur applies for, loan amounts range from $500 to $5+ million.
Borrowers must provide copies of their business plan, bank and financial statements, business legal documents, and other requested records. A bank lender reviews a business's personal and business credit scores to determine creditworthiness and may require collateral to secure the loan.
SBA loan rates are fixed and usually lower as compared to short-term loans. If a borrower needs quick cash, an SBA loan isn't a favorable option as the loan process and funding can take weeks, if not months.
SBA proceeds can be used for start-up costs, working capital, making repairs, or refinancing debt. Business owners also use the money to purchase equipment or to buy a business, land, and real estate.
Loan amounts are routinely issued for less than $50,000 making them a good option for entrepreneurs needing short-term financing. With fewer qualification requirements, microloans are a good source of quick capital to improve a business's cash flow and are especially popular with minority-owned business owners.
Interest rates are much higher than a traditional SBA loan because a lender assumes more risk. Generally, microloan lenders work with borrowers who have lower credit scores and are just starting their businesses without having business assets.
Borrowers can receive microloan funding in a few days and proceeds can be used for a wide variety of business costs. However, lenders may restrict fund usage such as not allowing borrowers to pay off loans or buy real estate.
This asset-based loan helps a business owner acquire new or used equipment when there's no cash on hand. A borrower with a low credit score usually qualifies for this loan because the lender can use the equipment as collateral, as explained by Fora Financial.
Interest rates vary depending on how long an entrepreneur has been in business and their existing financial history. In most instances, proceeds can be used to buy, repair, or lease equipment. These types of loans are beneficial for owners who want to grow their businesses quickly but lack immediate capital to make investments.
Business Credit Cards
Both start-ups and established businesses use business credit cards to pay for day-to-day expenses because they're a convenient and flexible source of immediate credit. A business credit card builds credit history and helps alleviate cash flow problems. But this financial instrument has its pros and cons.
Many cards come with rewards such as earning airline miles or cash back for making purchases. If balances are paid off monthly, they are an excellent source of short-term financing. If not, unpaid balances are subject to high-interest rates and associated fees.
Along with the most common types of small business loans already noted, invoice factoring and financing and merchant cash advances provide fast cash and are typically unsecured. However, these types of loans are more costly as compared to other financing options.
Business Line of Credit
Having access to immediate cash helps provide a cushion of money for emergency and other types of purchases. The amounts of business lines of credit range from $1,000 to $250,000, and you can use the money to pay for operating and unexpected expenses, to have access to extra cash between accounts receivable payments, or to hire staff. Many seasonal businesses even use a business line of credit as working capital during off-seasons.
Aside from flexible, they are also convenient since cash withdrawals can be transferred to a business account as needed. Banks set up a business line of credit as fixed or revolving and charge interest (as low as 5% or as high as 60% or more as stated in this comparison) on the unpaid balance. A business line of credit calculator can help you compute how much you’d have to pay each month to analyze if this is the best alternative for you.
You can choose to make minimum payments or pay off the balance in full each month. As explained in the Experian blog, once you pay back the line of credit, the money is available without needing to reapply or be reapproved. As long as you don't draw on the credit line, there are no payments to make each month.
One drawback of business lines of credit is that a bank can reduce or close the credit line if a business owner fails to repay withdrawals or make timely payments. Also, keep in mind that fees and additional costs vary per lender. Some financial institutions require an annual review to maintain the credit line.
Which financing option is right for your business?
Running a business is both challenging and rewarding. As an entrepreneur achieving success, you can’t take unnecessary risks that would jeopardize your company's future. That's why it's important to weigh the pros and cons of a small business loan or a line of credit before contacting a lender.
Business owners that want fewer restrictions and an adjustable monthly payment may choose a business line of credit. Getting a small business loan would be a good idea to build credit or to maintain a predictable budget.
This post provides a snapshot of which financial instrument makes the most sense for your business, and what you can expect when getting a loan or applying for a line of credit. Now you can make an informed decision and control your business's financial future. Don't delay to apply for funding to achieve your business goals.