How Do Business Loans Work?

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Finances are the driving force behind every business. At some point, the business will need more money than it can generate to remain afloat, fund an aggressive expansion or simply maintain cash flow. At such a point, most businesses turn to the most practical approach, which is taking out a loan.

Business loans, though not fully understood, are not a new concept. They have been around for ages and have fuelled the success and growth of many businesses and kept others from going under. The secret to making the most out of business loans is understanding how they work so business owners and entrepreneurs can carefully understand the risk and choose loans that best serve their needs without tying down their businesses for too long.

Here’s a closer look at business loans and how they work to help you understand the intricacies of these vital lifelines for businesses.

What is a Business Loan?

Business loans are a type of borrowing designed for commercial organisations instead of individuals. Like personal loans, you pay back the business loan on a monthly basis, and they have a payback period of up to 25 years, depending on the amount of money borrowed.

Business loans come in two primary categories. They can be short-term or long-term loans and can be secured or unsecured.

With business loans, you can borrow higher amounts at lower rates than with personal loans, but the application process is more complex, as the lender will want to look at your personal credit score as well as your business credit score and finances. Because of the bureaucracies and processes, getting your money with a business loan takes longer. It is just one way of getting a cash injection for your business.

If you’ve taken out a personal loan before, a business loan works more or less the same way. You make an application for the amount you require from a lender like a bank or other online lender. They will assess your qualifications for the amount requested and the applicable interest rate.

If they make you an offer, you decide whether the terms are accessible, and once the deal is agreed upon, you will receive the full amount. You must repay the amount plus interest over the loan’s lifetime in monthly payments.

What Can You Use a Business Loan For?

When applying for a business loan, you must indicate the purpose of the loan. While some loan providers are strict about the purpose of the loan, others are not. You can use the loan for various applications within the business. Some of the ways you can use your business loan include the following;

Everyday operations

Running a business requires substantial finances daily. You can use the loan to cover running costs such as payroll and rent. Financing can be a great tool for companies experiencing extreme cash flow challenges, requiring money to stay afloat until their seasons change.

Purchase equipment and machinery

Most businesses require machinery and equipment for their operations and growth. With a business loan, you can finance the purchase of new equipment and machinery to grow your operations or replace worn-out and failing equipment. In this case, you can take out a loan to avoid wiping out your cash flow and business savings to purchase the equipment.

Debt refinance

Using one loan to clear another is increasingly becoming common among businesses for several reasons. The most common one is getting better and more affordable loan lending terms. You can take out a business loan from one lender to clear a debt with another lender. The new lender might offer more flexible and favourable payment terms that make it easier for the business to pay off the new lender than the initial lender.

Expansion

Contrary to popular opinion, business loans are not a preserve of failing or struggling businesses. In fact, most business loans are used for growth and expansion purposes, which indicate success for the business. You can use the loan to buy another business, set up a new outlet or building or expand into another floor.

Buy inventory

Business loans can also be used to purchase inventory to keep up with customer demands. If you’re running out of products or stock, which could interrupt your revenue, you can use a business loan to stock up and prepare for your high season.

You can also use business loans on:

  • Marketing or advertising to raise your profile and attract new customers
  • Take on new staff or invest in your existing staff by providing training
  • Cashflow for everyday expenses
  • Business Franchising

What you can use your business loan for depends on your type and agreement with the lender. Some are flexible, while others will only offer loans to finance specific activities.

Types of Business Loans

Over the years, financing institutions have come up with different types of loans to meet different business needs. As a result, your business has access to various types and categories of business loans. However, these types of loans all fall into two main categories;

  1. Unsecured loans: These loans allow the business to borrow money without having to use its assets as security. The loans in this category are often short-term and for smaller amounts.
  2. Secured loans: These are loans that require your business to commit an asset to the lender when borrowing. If you don’t repay the loan, the lender can sell the asset to get their money back. Generally, secured loans have a lower interest rate than unsecured loans and are commonly used to borrow large amounts.

From these two main categories of business loans, you get other specialist business finance depending on your industry or sector. Some of the main types of business loans available are;

Bank loans

These are probably the most common and popular types of business loans. They are cash loans extended by banks and building societies. Your business borrows a lump sum and pays it back over a set period with interest.

Bank loans often require security or personal guarantees for unsecured business loans. If the business cannot repay the loan, its directors or owners will be personally liable for the debt.

Revolving credit facilities

A business credit facility lets you borrow money as and when you need it. Instead of taking out a large lump sum, you have regular access to funds with a certain set ceiling. This method of financing is more flexible than a standard business loan and only requires that you pay interest when you withdraw money from the credit facility.

However, instead of paying the money in instalments, you pay it back in its entirety once the funds are available, plus interest. You can pay the money and then withdraw it when using revolving credit facilities.  

Peer-to-peer lending

This is a social type of lending offered by online lending platforms. You borrow money from private investors looking for a return on their money. Peer-to-peer lenders may ask for a personal guarantee when you apply for the loan. The interest rates might be slightly higher, but they mainly concentrate on small, short-term business loans to minimise their risk exposure.

Asset-backed loans

These are secured loans backed by a business asset. They allow the business to borrow more money at a lower interest rate. This is a more common type of business loan and is more affordable. Some of the assets that can be used to secure this type of loan include;

  • Machinery
  • Property
  • Stock
  • Land
  • Vehicles

Invoice finance

Invoice financing is slightly different than your average cash loan. In fact, some might even make the case that it is not a loan.

Rather than lending you a cash lump sum, you use your outstanding invoices to get an advance for a fee. The invoice financing company gives you a cash advance of up to 90% of the value of the invoice and sends you the balance once your customer pays the invoice, minus their fee. There are two types of invoice financing options;

  • Invoice factoring: this is where the invoice factoring company takes over the invoice collection from your clients.
  • Invoice discounting: You maintain the responsibility of collecting the invoice. The lender gives you a percentage of the funds before the invoice is paid and the balance once the invoice is paid.

Invoice financing is available from banks, building societies and independent companies specialising in this type of financing. Unlike conventional bank loans, with invoice financing, the business is not taking up any debt and will not make any payments to the company.

Cash advance

A business cash advance loan is where you borrow money against future debit or credit card sales. For instance, the business can borrow money to refurbish their premises and then pay it back by having 20% of every card transaction shaved off until the cost of the financing is paid. This means you end up paying more when takings are higher and less when they are lower, making this a flexible way to borrow.

Working capital

A working capital loan helps with the daily running of the business. It helps to keep up with the running costs such as wages. It is not a long-term loan or investment; therefore, many working capital loans require a personal guarantee from company owners or directors.

Government-backed loans

Government-backed loans are specific loans used mostly for startup businesses or existing businesses that have been trading for less than three years in the form of unsecured business loans.

Businesses can borrow up to £25,000 under this scheme and pay it over five years. These loans usually have a fixed rate of interest with no other fees on top of this. The loans are typically accessed through various government-appointed banks.

Business vehicle finance

This type of business loan helps you buy vehicles for your business, like vans, cars or trucks, which you may need to run and expand your business.

Instead of paying upfront for the vehicles, you can spread the cost by paying for them monthly. You can do this through hire purchase, leasing or contract hire.

How Much Can You Borrow with a Business Loan?

Several factors determine how much you can borrow when applying for a business loan. You can borrow anything between £500 to £15 million with a business loan, but what you can get approved for depends on how much the lender will agree to lend you.

Factors like your business’s finances and how much you can afford to pay back, your credit history and that of your business are all factors that will determine how much the lender can give you.

When borrowing, you should also know there are various repayment methods available. They generally range between one month and 25 years. Choosing a longer repayment time might reduce the monthly repayment cost but usually means paying more interest and fees than when paying within a shorter time.

The duration of the loan also determines how much you can borrow. Short-term business loans often have a lower limit. You could potentially borrow for just a few days. Short-term businesses often charge higher interest rates than other types of loans, but you should make sure you know exactly how much it will cost before applying for the loan.

Business Loan Requirements

Not all businesses qualify for all types of loans. When looking into a business loan, you need to consider the loan provider’s requirements and your business’s eligibility. This will save you application time, only to get turned down because you don’t qualify.

For instance, if your business doesn’t generate invoices, you cannot opt for invoice financing because invoices are a part of the requirements.

Lending policies and criteria vary between providers and the type of loan you’re looking for. Generally, some of the requirements and assessments required for business borrowing include the following:

  • Annual turnover – Most lenders have a minimum business revenue or annual turnover requirement to qualify for a loan. This requirement varies widely depending on the type of business loan you’re interested in and how much the business wants to borrow.
  • Time in business – Some loans will need the business to have been trading for a certain period, such as three years. However, loan options for newer businesses and startups are also present.
  • Credit check – The provider will need to check your credit and as well as that of the business before lending. If the business has had payment or credit problems in the past, the loan application may be rejected. Alternatively, you may get higher interest rates if you have a spotty credit history.
  • Debt ratio – This is the business’s assets relative to its total debts. Lenders usually assess this at the point of making a decision to determine the business’s ability to pay the debt. If the ratio is too high, the lender might reject the application.
  • Security – With secured loans, the lender will need you to put some security as collateral against the loan. This might be a business property or other asset that is of similar or higher value than the amount being sought. To ensure this, the lender will evaluate the security you put forward. Remember that the lender will seize the security if your business cannot pay the loan.
  • Personal guarantee – This is not a requirement for all loans. However, it is common for lenders to require a personal guarantee, which protects the lender in case of a default. If you take on a personal guarantee, the lender will require you to repay the debt with your personal funds if your business can’t pay or meet its loan agreement terms.

Besides the highlight requirements, you might also want to consider other factors that might keep you from getting business loans, such as low credit scores. Also, understanding the business loan application process and what to avoid before applying for the loan can be vital in increasing your chances of getting approved for the loan. 

Who Can Apply for a Business Loan?

Most businesses can get a loan of some kind. However, your options are limited by the type of business, size and how long you have been in operation.

Government startup loans are only available to new businesses that have been trading for less than three years. Cash advance loans require you to have been trading for some time before you apply.

It may be harder to get a business loan if you’re a sole trader rather than a limited company. Sole traders are seen as higher risk, and you don’t have to file your annual accounts with Companies House.

Basically, every business has access to some sort of business loan. You just have to determine the types of business loans your company qualifies for.  

How to Apply for a Business Loan

The process of applying for a business loan begins with completing the application online or physically at the lender’s branch. Sometimes, making an enquiry before filling out the application can reveal vital information that might prove helpful in deciding whether you should apply for the loan with the lender or look for other alternatives and whether your business meets the lender’s requirements.

You will need to provide a range of documents so the lender can assess you for the loan. The most commonly required business bank statements include statements from the last six months and your accounts. Getting these together before applying for a loan is a good idea.

Other documents required for the loan application process include proof of any other finance you have, details of business assets if you’re using them as security, a business plan, financial forecasts and balance sheets.

The lender will also check your business credit report. You can get a copy of the credit report from a credit reference agency before applying for the loan to ensure it is accurate and up to date.

You can also improve your chances of being granted the loan by paying off any outstanding debts, if possible, and calling in the money you’re owed.

Invoice financing companies will also require you to fill out some paperwork, but the accompanying paperwork is not nearly as extensive as what you would need for a bank loan. Some may not even require a credit report. However, you need a good credit record for peer-to-peer lending.

Besides the application process, with secured loans, the additional step of valuing the assets could prolong the loan process. 

What Happens if I Can’t Repay My Business Loan?

There are different levels to missing business loan payments. First, if you miss a payment, there are late payment fees and extra interest charges. Some lenders might also throw in some administration fees, making your next instalment more costly.

Also, the lender can register the missed payments with your business’s credit record, which will make it more difficult to get financed in the future, especially if you default on the loan.

You can be considered to have defaulted on a loan if you fail to make two or three payments. However, the exact terms will be set out in the loan agreement.

If you have taken out a secured loan, the lender can seize your assets to recoup the money. If it is an unsecured loan with a personal guarantee, you will have to pay it back yourself, or the lender might pursue you to repay it.

Lenders also have legal options available to them to ensure you repay the money you borrow. This can include garnishing your wages for personally guaranteed loans.

How You Can Pay Back a Business Loan

Once the loan is approved and credited to your account, you must start paying it back. How you pay it back depends on the type of loan and the loan agreement. Some of the common ways businesses pay loans include;

  • Direct debit
  • Standing order
  • Direct from outstanding invoices for the case of invoice finance
  • A set percentage of your card is taken for cash advance loans.

You should ensure the loan is paid on or before the due date every month to avoid hefty charges on a negative report on your credit.

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