Types of Business Loans
Navigating the landscape of business lending can be overwhelming, with thousands of lenders offering various commercial loan products, each with its unique characteristics. While many loans are variations of a few core financing products, differences in approval processes, funding delivery, and repayment methods abound. Technological innovation, particularly in financial technology (fintech), has revolutionized the lending landscape, enabling rapid analysis of a company’s financial situation and expediting the approval and funding process.
Given the dynamic nature of loan products and the proliferation of alternative lending, understanding business financing options can be challenging, especially considering the lack of regulation in some cases. In this article, we will delve into the most commonly used types of business loans available to small and medium-sized enterprises. We will compare rates and terms associated with each financing product, provide explanations of how they work, and outline the funding process. Additionally, we will weigh the pros and cons of each product to equip business owners with a comprehensive understanding before they embark on the application process.
What is Debt Financing?
Debt financing involves businesses raising capital by borrowing funds from lenders such as banks, financial institutions, or private investors. In this method, the borrower is obliged to repay the borrowed principal amount along with interest over a specified period, as per the terms of the loan agreement. Unlike equity financing, debt financing doesn’t involve giving up ownership stakes in the business. Common types of debt financing include loans, lines of credit, bonds, and commercial paper.
What are the Pros and Cons of Debt Financing?
PROS: Maintaining control of your business. Debt financing allows you to retain full ownership and control over your company. Unlike equity financing, where you may have to give up a significant portion of ownership in exchange for funding, debt financing does not dilute your ownership stake. This means you won’t have to share future profits with the lender.
Do All Debt Lenders Require Collateral?
No, not all debt financing companies require collateral. However, many, if not most, do typically require some form of collateral, business guarantee, or personal guarantee. Lenders often place a lien on business or personal property to protect themselves and mitigate losses in case of borrower default. That being said, there are non-collateralized options available. Some lenders primarily consider the value of collateral for financing, while others focus more on cash flow, and there are options that fall in between these extremes.
Secured Business Loans
Unsecured Business Loans
Financing that does not necessitate collateral. Business lenders offering unsecured financing typically prioritize cash flow and focus on the creditworthiness of the business and owner, or future revenue projections. To mitigate their risks, unsecured lenders may require daily or weekly repayments. While some unsecured lenders do not require general business and personal collateral, they may acquire current and future business receivables.
| Type | rate | terms | Funding |
|---|---|---|---|
| Bank | 6-10% | 3-7 Years | 14-30 Days |
| SBA | 6-10% | 3-7 Years | 10-30 Days |
| Line of Credit | 5-15% | 1-3 Years | 7-30 Days |
| Alternative | 6-2% | 1-5 Yeras | 5-7 Days |
| Cash Advance | 1.16 - 1.55 | 3-24 Months | 1-3 Days |
| Invoice Finance | 1-2% Weekly | 1-90 Days | 1-3 Days |
Approval Rates
Traditional Banks
Alternative Lenders
Cash Advance Lenders
Large Banks
Term Business Loans
Term business loans represent the standard and most prevalent form of business financing, typically featuring a maturity period spanning 1 to 25 years. Repayment is structured on a predetermined schedule, commonly monthly but occasionally weekly, until the principal amount plus interest is fully repaid. Interest rates for term loans are often determined by an Annual Percentage Rate (APR) or a factor rate. Various fees accompany term loans, including origination fees, banking fees, and others, which may vary among lenders.
These loans serve a multitude of purposes, including the acquisition of businesses, commercial real estate, working capital, business equipment, inventory purchases, and more. Term loans can be either secured against business or personal assets or unsecured. Approval rates for term loans vary significantly, with traditional lenders imposing stringent requirements and achieving approval rates as low as 20%, whereas alternative lenders may have approval rates as high as 70%.
The process of securing a term loan involves providing documentation detailing the business’s performance over recent years and projecting future performance to demonstrate the ability to service the new debt. Required documents typically include business and owner tax returns, financial statements, and other pertinent business records.
Pros
- The most favorable interest rates among all types of business loans
- Interest payments are eligible for tax deductions
- Extended repayment durations ranging from 1 to 30 years
- The most economical fees among all business loan options
Cons
- A more intricate approval procedure compared to many other business loan options
- Mandates an equity injection from the borrower
- Necessitates more extensive financial documentation than alternative small business lenders
Asset Based Lending
Asset-based business loans (ABLs) are specialized commercial financing options designed to offer collateralized loans to small businesses facing challenges such as high leverage, irregular earnings, or cash flow issues. These loans leverage business assets as collateral, providing financing by utilizing assets listed on the company’s balance sheet. Collateral may include commercial and personal real estate, inventory, accounts receivable, equipment, machinery, invoices, and other assets. ABLs are available through both traditional and alternative lenders, with various types of facilities offered.
For instance, accounts receivable (AR)-based ABL lenders may purchase future receivables from the company and advance cash, deducting a discount. The ABL application process typically involves extensive documentation related to collateral, including appraisals, title searches, UCC searches, and aging schedules for accounts receivable and accounts payable. Additionally, the company is required to provide financial documentation such as tax returns, income statements, balance sheets, and a schedule of liabilities.
Pros
- Immediate access to funds, eliminating the necessity to await receivable collection.
- Emphasis on the caliber of business collateral over credit rating.
- Require fewer documents compared to traditional business lenders.
- A bridge facilitating the interim between fund receipt and business expenditure.
- Tailored and flexible business financing solutions
Cons
- Higher rates and fees compared to traditional business loans.
- Loss of control, as a third party typically gains authority over the small business's cash flow.
- Fees associated with the loan can be significant.
Business Line of Credit
Pros
- Instant access to business funding without the need to await lender approval.
- Access to capital in flexible increments as needed, rather than a lump sum.
- Interest is solely accrued on the funding utilized by the small business.
Cons
- May pose challenges in securing other forms of commercial financing.
- Lenders demand upfront and maintenance fees from the business.
Alternative Business Financing
Alternative business loans come in a wide array of options, each with its own set of characteristics. Typically, alternative loans are offered by non-bank lenders and feature interest rates falling between traditional bank rates and high-interest cash advances. These lenders are often institutionally based, utilizing investor funds to provide financing to businesses. As a result, the rates are higher than those of banks, reflecting the investors’ willingness to take on riskier lending opportunities.
One of the primary advantages of alternative lending for borrowers is the streamlined approval process, which can be completed in hours or even minutes, with funding available in as little as a week. Alternative lenders place significant emphasis on future earnings and cash flow rather than credit history. They assess recent cash flow patterns and project the borrower’s ability to service debt in the future.
- Midprime alternative loan rates typically range from 9% to 25%.
- Midprime alternative loans typically have terms ranging from 1 to 5 years.
Pros
- Lower credit requirements compared to traditional bank loans.
- Rapid approval process (typically within 2 days).
- Speedier funding process (usually within 2 to 7 days) compared to traditional small business lenders.
- Less documentation is necessary in comparison to traditional small business loans.
- Offering superior rates compared to Merchant Cash Advance Loans.
Cons
- Interest rates are higher compared to those offered by traditional small business lenders.
- Terms are shorter compared to traditional bank business loans.
- May entail costly fees.
Bridge Financing
Bridge financing serves as a short-term business loan primarily utilized for capital needs until a small business secures longer-term financing from a commercial lender or receives payment from a customer. It is commonly employed for commercial real estate financing or working capital purposes. Commercial real estate bridge lenders typically finance commercial real estate while the borrower finalizes permanent financing. Conversely, working capital bridge lenders offer financing to sustain business operations until longer-term financing is secured or until payment is received from clients or vendors.
The process for obtaining bridge loans varies among lenders, but they all feature expedited funding. While commercial bridge loans may involve appraisals of commercial real estate that can prolong the process, working capital bridge lenders may provide financing within a day, requiring only an application and the company’s bank statements.
Pros
- Provides immediate cash flow for small businesses while awaiting permanent commercial financing.
- Require fewer financial documents compared to traditional small business lenders.
Cons
- Bridge loans typically feature higher interest rates compared to traditional types of business loans.
- Shorter terms than other loans
- May necessitate property as collateral.
Factoring and AR Financing
Factoring, also known as accounts receivable financing, involves the sale of accounts receivable to third-party small business lenders at a discount. It is not a business loan.
Pros
- Factoring is not a business loan, so there's no debt incurred with a business lender.
- Employing a factoring company can promptly assist a small business in fulfilling its current and urgent cash requirements when traditional business loans are not a feasible financing option.
Cons
- Involves fees that other lenders typically do not require.
- Only a fraction of the receivable amount is advanced.
Equipment Leasing
Equipment financing encompasses various financing options for acquiring or leasing business equipment. This includes term loans, advances, and equipment leasing. In equipment leasing, a commercial lender procures the equipment and leases it to the small business for a predetermined period, with an option to purchase the equipment at the end of the term.
Pros
- Leasing equipment enables small businesses to access equipment financing without needing to pay the entire cost of the business equipment upfront.
- Leasing your business equipment incurs fewer initial costs compared to making full purchases.
- Having an option to purchase the equipment at the end of the leasing agreement grants the small business the right, though not the obligation, to buy the equipment.
Cons
- In the long run, leasing equipment may often result in higher costs compared to purchasing business equipment with a traditional business loan.
- When leasing business equipment, it's common to pay up to 25% more than the equipment's value after factoring in the deposit, monthly payments, and leasing fees.
Merchant Cash Advance
Merchant Cash Advance (MCA) business loans provide a lump sum payment to small businesses in exchange for a percentage of their future sales. Unlike traditional business loans, repayments are typically made through Automated Clearing House (ACH) transfers, with fixed daily payments deducted directly from the business’s bank account on business days. Alternatively, some MCA arrangements involve repayment based on a percentage of daily deposits rather than fixed payments.
- Merchant Cash Advance (MCA) terms typically range from 4 to 24 months.
Pros
- Merchant Cash Advances (MCAs) offer the fastest approval process among all types of business loans.
- Most business advances accept bad credit, making them accessible to a wider range of businesses.
- Funding is typically faster with business advances compared to loans from traditional small business lenders, usually taking only 1-5 days.
Cons
- usiness advances are typically the most expensive type of business financing available.
- Short terms
- Repayments for merchant cash advances are typically made on a daily basis.
- High fees are commonly associated with merchant cash advances.
